Exchange Rate Regimes

What are fixed Exchange Rates?

- Officials commit to maintaining the exchange
rate at a specific level.
What are Floating Exchange Rates?
- No intervention from bankers or government
officials. The market determines the price of the
currency.
What is a “clean” float? A “dirty” one?
- With a dirty float the government doesn’t peg the
currency, but tries from time to time to influence the
rate by buying or selling in the currency markets.
 Exchange Rate Regimes
What is a “clean” float? A “dirty” one?
- With a dirty float the government doesn’t peg
the currency, but tries from time to time to
influence the rate by buying or selling in the
currency markets.
Fixed Exchange Rates:
The government must buy the amount that will bring
the quantity demanded back to the original level
 Fixed Exchange Rates
• How can the government keep a currency at a
certain value if international commerce becomes
unwilling to pay that price?
• It can’t maintain the value for long. If the demand
for the currency falls, it’s price would fall as well.
• The only way the price can be kept up is for the
government promising to maintain the original level
to enter the foreign exchange market and bid the
price of the currency back up by purchasing it.
 Fixed Exchange Rates
• To what does the government fix the value of
its currency?
• When or how often does the country change
the value of its fixed rate?
• How does the government defend the fixed
value against any market pressures pushing
toward higher or lower exchange rate value?
• In the past, all currencies were fixed to gold.
• Today, a country can fix its value to another
country’s currency
 Fix to what?
• A country can fix its currency to a “basket” of other
currencies.
-Same as diversifying a portfolio (Not putting all your
eggs in one basket)
-Special Drawing Right (SDR)…A basket of four
major world currencies.
 How can higher i rates keep the currency value up?
 (Answer: Foreigners will purchase the nation’s currency,
bidding its value upward, to make short-term investments
in the country.)
 Defending a Fixed Exchange Rate
1. To buy or sell foreign currencies (in order to
influence the prevailing exchange rate), a
government must have foreign exchange
reserves.
2. It is not likely to have enough reserves to defend
against a massive and sustained attack on the
currency. What is an attack on a country’s
currency?
(Answer: Massive “selling off” of a currency
expected to be devalued. One can borrow the
attacked currency and pay it back after
devaluation.)
 Defending a Fixed Exchange Rate
3. The government can also make long-term adjustments of
its macroeconomic (monetary and/or fiscal policy).
Budget austerity (self-denial because of external
pressure) avoids inflation and takes downward pressure
off currency.
1. Why does inflation put downward pressure on a
country’s exchange rate?
 Non-inflating countries are unwilling to pay more and
more to buy an inflating country’s goods and services.
Reduced demand for the inflating currency will make it
depreciate.
 Defending a Fixed Exchange Rate
3. Why does inflation put downward pressure on a
country’s exchange rate?
 Citizens of the inflating country will want to seek
bargains through imports, selling their currency to obtain
other currencies. Selling increases the supply and drives
the price down further.
Assume the Peso has been inflating in Mexico
Downward pressure will be on the peso. (Less demand for it,
since fewer will be purchased with Mexican prices going
up.)
1. The Mexican government intervenes in currency
markets, purchasing pesos to maintain their value and
promises it will never permit its value to fall.
 Defending The Peso Under Attack
4. The attack will be under way if people don’t believe the
promise. People sell their pesos for dollars, etc., while the
price is still up. Note: borrow money in Mexico, change it
quickly for dollars. Pay back the loan later with cheap
pesos.
5. The Mexican government soon runs out of reserves and
lets the peso price fall.
6. People purchase pesos back at the new, lower rate for
good gains.
 When to Change the Rate?
• Why might a government want to change the exchange value of its
currency?
• It might do so in order to promote, for example, greater export
volume.
• What is a pegged exchange rate?
• The term pegged exchange rate refers to setting a targeted value
for a country’s foreign exchange, and it indicates the govt. has
some ability to move the peg.
• Clean Float
– Supply and Demand are solely private activities
– Complete flexibility
• Dirty Float (Managed Float)
» From time to time, the government tries to impact the
rate through intervention
» More popular than clean float
» Effectiveness of intervention is controversial
 When to Change the Rate?
• Governments attempt to keep the value fixed for relatively long
periods of time to reduce trade uncertainties.
• What is an adjustable peg?
• The government may change the pegged rate if a substantial
disequilibrium in the country’s international position develops (e.g.,
demand for the currency is too weak to maintain the desired value).
• A crawling peg can be changed often (monthly, say) according to a set
of indicators or the judgment of the country’s monetary authority.
• Indicators:
– The difference of inflation rates
– International reserve assets
– Growth of the money supply
– The current actual market exchange rate relative to the
central par value of the pegged rate
 Monetary Policy with Fixed Exchange Rates

Expanding the Money Supply Worsens the Balance of Payments

Capital flows out.
(in the short run)

To improve a poor The overall

Interest rate
macroeconomic payments balance
drops
situation, a “worsens.”
country increases
its money supply
so that banks are
more willing to The Current account
Real spending,
lend. balance “worsens” as
production, and
exports fall and imports
income rise, but
increase.

The price level

increases.
 Monetary Policy with Floating Exchange Rates

Effects of Expanding the Money Supply

Capital flows out.

(In the short run)

Currency The Real

With an Interest
depreciation and Current product
increase in the rate
automatic account and
money supply, drops
adjustment begins! balance income
banks are
more willing improves rise more
to lend.
Real spending, Current account
production, and balance “worsens.”
income rise.

The Price level

increases.
(Beyond the short run)
 In Conclusion
• Fixed exchange rates are government controlled.
• Floating exchange rates are market driven.
• Governments have always preferred the improved business
climate of fixed rates
– They reduce the uncertainty of unstable currency values (note
the European Monetary System’s fixed rates of the 1990s).
But as financial markets have developed to
accommodate for flexible exchange rates, more
and more countries have come to appreciate the
value of market determination.
 Kenen on Fixed and Floating Rates
• Times have changed since the early 1970s and Nixon’s destruction
of Bretton Woods. Markets have developed to hedge exchange risks
and we have become accustomed to the uncertainties associated
with them. Trade flourishes.
• Fixing the exchange rate deprives a government of two very
valuable policy instruments, the nominal exchange rate and
monetary policy, and it may therefore be tempted to adopt beggar-
thy-neighbor trade policies to cope with output-reducing shocks.
• The reading by Peter b. Kenen, “fixed versus Floating Exchange
Rates” is probably expressive of a majority of economists.
• Once, during the era of the Bretton Woods System, many feared
floating rates. Their uncertainty would hinder international trade
 Kenen on Fixed and Floating Rates
• Fixing the exchange rate may help stabilize a country that has
suffered extensively with inflation. trade policies to cope with
output-reducing shocks.
• The commitment to a pegged exchange rate is implicitly a
commitment to monetary and fiscal stability, without which a fixed
rate cannot survive. Pegging can buy credibility.
• When asymmetric economic shocks trouble nations, some cannot
cope without changing their exchange rates. “It is neither wise nor
realistic to advocate world-wide pegging.”
 Richard N. Cooper on
Exchange Rate Choices
• Many countries have gone to the float for their exchange rates,
but many still decide to peg their currency or fix their exchange
rate. The choice is probably the most important macro-
economic policy decision a country makes.
• Cooper reviews the international monetary experience among
the major countries, reviewing the reasons why floating rates
were long viewed with suspicion.
• He discusses the Friedman/Johnson case for flexible rates
made in the sixties and seventies. Johnson thought the
developing countries would continue to peg their rates.
 Richard N. Cooper on
Exchange Rate Choices
• Cooper reviews the potential pitfalls for developing countries when
international institutions insist that they both move to greater exchange rate
flexibility and to liberalize international capital movements at the same time.
• Flexible exchange rates have worked very well for the leading industrial
countries. It will be interesting to see how Europe fares with absolutely fixed
exchange rates among EU members (via the Euro) and how the Euro/U.S.
Dollar relationship develops.
• We’re still learning, but movements in exchange rates provide a useful shock
absorber for real disturbances to the world economy, but they are also a
significant source of uncertainty for trade and capital formation, the
wellsprings of economic process.