Lecture 7_8-Flexible and Fixed Exchange Rate System

8/9/2019 Lecture 7_8-Flexible and Fixed Exchange Rate System

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Flexible and FixedExchange Rate System

Lecture7_8

By Preeti Singh



FIXED !D FLEXIBLE EX"#!$ER%ES

• Flexible Exchange Rates

• Semi Fixed Rate System

• Flexible Exchange Rates• Liberali&ed Exchange Rate

'anagement System (LER'S)

*++,• -ni.ed Exchange Rate *++/

• "urrent cc0unt "0n1ertibility

• "a2ital cc0unt "0n1ertibility



•Gold standard

•Bretton Woods

•Pegged rate

•Currency board

Fixed Exchange Rates



Semi Fixed Rate

System • Bands

• Target zones

• Pegs and Baskets

• Crawling peg

• Floating rate

system



• It is a market determined rate of

interest.• RBI has made the value of the rupee

within a band and according to the

basket of currencies mechanism.• It uses the American dollar as the

intervening currency.

F l o a t i n g R a t e S y s t e m



• Flexible exchange rates are

determined by the 3ree 2lay 03demand and su22ly 03 30reignexchange4

• %he 5exible exchange rates are6n0n as 5uctuating 0r 50atingexchange rates4

•%he exchange rate is als0

Flexible Exchange Rates



!0minal9 Real and Eecti1eExchange Rates

• The nominal, real and efectiverates are depicted o domesticcurrency as per unit o oreign

currency to make an analysis othe efects and changes in theoreign exchange rate

• Nominal exchange rate

• Real Exchange rate

•

Efective exchange rate



• %he n0minal exchange rateis the 2re1ailing exchangerate at the time hen it isbeing analy&ed4

• It is the 2rice 03 0necurrency in terms 03an0ther4

ominal exchange rate



Real Exchange rate

• The real exchange rate measuresthe purchasing power of a currency.

• • It can be calculated by adjustingthe nominal rate of exchange for

relative prices between thecountries that are being analyzed.



Effective Exchange Rate

• %he eecti1e exchange ratemeasures hether the 2rice 03 acurrency is a22reciating 0rde2reciating against theeighted bas6et 03 currencies

ith h0m the c0untry desirest0 trade4

• %he real eecti1e rate changes

ith0ut any change in exchange



Flexible and Fixed ExchangeRate System

Fl0ating Exchange Rate• !ince "#$%& most industrial countries and many

development countries allowed their currencyto 'oat with government intervention in theforeign exchange market.

"raling Peg

• (rawling peg is also called sliding and gliding

parity.• It is a cross between a )xed rate and fully

'exible system.

• *hey are semi )xed system but not 'oating

system.



• (rawling peg were developed to ad+ust therate slowly by small amounts at any point oftime on a continuous basis to correct over

valuation and under valuation.• *he small ad+ustment between ,.- per

month or / for the whole year wasdesigned to discourage speculation by

setting an upper limit that speculators couldgain from devaluation in one year.

• *he disadvantage of this system is that it

re0uires countries to have ample reservesfor process of ad+ustments.

• 1inor ad+ustment may not correct currenciesover valuation and under valuation.



:ide Band

• 2b+ective of wide band is to compensate

for the rigidity of the )xed rate systems.• *hey are similar and yet di3erent to

ad+ustable peg system.

•

4ide band allows currency value to'uctuate - on each side of the par.

• *his system uses more 'exiblemovement to warn speculators for moreadverse conse0uences when predictionof direction of exchange rate proves tobe wrong.



%y2e 03 :ide Band•

A group of European ations used aparticular form of wide band.

• Exchange rate gyrations since the abolitionof )xed rate was a special problem forEuropean countries because of theirdependence on trade within the block.

• !nake was created for less formal of stable

but 'oating rates among their currencies.• 5oal was exchange rate stability& unity 6

cooperation.



• 4est 5ermany& Benelux and!candinavian countries in April "#$7

entered into European 8oint FloatAgreement called 9the snake:.

• *he snake is a system of stable but

'oating rates.• It is a currency band that links these

countries currencies and their values

)xed against one another in narrowband of 7.7- above and below thepar value.

•

*he ;.- limit for +oint 9twists of the: 9 :



• *he snake had too many problems soit could not achieve its goal.

• It was unable to protect the membercurrencies from the dollar slump in the"#$,s.

• (urrencies were forced out of thesnake by divergent economicconditions in the member countries

recurring market pressures andmember countries pursuit ofindependence ob+ectives.

•

Based on their economic policies



• In the wide band scheme& a country with morein'ationary policies will )nd the prices of theinternational goods going up re0uiring adepreciation program to correct the country:sbalance of payments in order to slow growthand curve in'ation while eventually riskingrecession.

• *he countries exchange rate would then sinktowards the 'oor under its par value.

• 2ne )xed limit is reached after hitting either

'oor or ceiling the country goes back to therigid )xed rate again.

• If wide band is desirable because of increase in'exibility& a country may be better of with no

limit for movement at all.



Flexible Fl0ating System

• In August "-& "#$" <! suspended convertibility

of dollar into gold and other reserve assets and'oated the dollar to change in the parity andreview of I1F.

• *he !mithsonian Agreement brought aboutrevaluation of many currencies and devaluationof <! = by ",.%-.

• In February "#$%& second devaluation of ",was brought about by <!.

• Foreign exchange markets closed down inEurope and 8apan for 7 > weeks.

• 4hen markets reopened& all ma+or currencies

were allowed to 'oat.



• ?ollar sank for $ weeks due to balance ofpayment de)cit.

• 4atergate scam brought about in'ation in<! and tightening of money abroad.

• 4ith dollar free to 'oat speculator pressures

showed a fall in the exchange value of thedollar without closing in the market.

• *he devaluation helped the <! to improveits trade performance.

• In 2ctober "#$@& <! = crisis happened asthere was panic selling of the dollar andstock markets fell.



Flexible System

•

In a 'exible system& market is based ondemand and supply to determinedcurrency values.

• A surplus in the country results in

appreciation of the currency.• It also creates higher prices increase in

reserves and opportunity costs.

• *oo much reserve reduces investmentopportunities.

• A country de)cit will lower its currency:svalue& make it easier to export.



FL;%• In the absence of government

intervention& 'oat is set to be 9clean:.

• Float is 9dirty : when central bankintervention in'uences exchange rates.

• A country with in'ation must reducepublic spending and money supply tocool the economy.

•5overnment intervention is to gain tradeadvantage.

• *oo much competitive devaluation

creates 9!lthy "oat :



E1aluati0n 03 Fl0atingRates

• Fixed rate and 'oating rate system havedi3erent characteristics.

• *he systems cannot have same goals ofcertainty& stability and in'ation control.

• Fixed rate plan are rigid but expertspreferring rigidity state that it bringseconomic eciency& public con)dence and

in'ation control.• Experience shows that )xed rates do not

work for a long time but from "$#7 to"#$"& )xed rates continued.



• For )xed rates to work the gold pricemust be )xed to control in'ation

which is impossible.

• Fixed rates also bring about massive

capital 'ows in a crisis and closing of)nancing markets.



%y2es 03 "urrencySystem

•

Fl0ating currencies are said to encouragein'ation in fact it makes it more apparent.

• '0re Flexible Exchange Rate Systems < 8apanand <! are in this arrangement and allow it to'oat in relation to each other.

5overnment intervention has an impact oncurrency value on the short run.

• 'anaged Fl0ating Exchange System have noocial bands on currencies.

5overnment intervenes to get its ob+ective done. Itallows government to implement their policywithin a relative 'exible exchange rate systemand to coordinate policies with other government.



• Pegged Exchange Rate< In peggedexchange rates are )xed in relation to

other currencies such as <! dollar&Euro and (urrency Basket with !?R orreserves by I1F.

*he disadvantage of a central bank to)ght the market maintain the system ifin'ation rate in two countries is thesame.

• Limited Flexible Exchange RateSystem< *hese are two types aC 5olf(ountries and bC European Exchange

Rate 1echanism.



*his system combines )xed peggedperiod and 'oating rate more 'exible

system.In "###& E(< was renamed Euro and

currencies in the ER1 were pegged

to the central rate.• ER1 moved from limited 'exibility to

the pegged portion expect ?enmark

all other countries chose to peg theircurrencies to the Euro.



Fixed =ersus Fl0ating ExchangeRates

• Dolatility in foreign exchange ratesrepresents a cost of doing businessinternationally and imposes

considerable risk on investmentsoverseas

• istorically governments tried toavoid this cost by )xing exchangerates at some predetermined level



Fixed =ersus Fl0ating ExchangeRates

• Fixed exchange rate system – *his was the system maintained globally

from "#;; until the early "#$,s.

– It came under the supervision of theInternati0nal '0netary Fund (I'F)

– After the collapse of the )xed exchange

rate system& it was resurrected with amore limited scope in "#$# for the ma+orEuropean countries



Fixed Dersus Floating Exchange

Rates•

Fixed exchange rate system – *he most recent example of a )xed

exchange rate is the introduction of theEur0 as the common currency of the "7

members of the #uropean $onetary%nion

• *his new monetary union sets the

exchange rate between the Euro and themember countries: national currenciesat a )xed rate

• Individual member countries are

expected to maintain domestic



• #0 Fixed Rates re Su220sedt0 :0r6 – *he correction process under a 'oating

exchange rate system• (ountry runs a balanceofpayments de)cit

• !upply of its currency o3ered on world)nancial markets exceeds the demand

•

*he currency will be depreciated in valuerelative to other markets

• *his ad+ustment brings the internationalpayments into e0uilibrium




Rates

• #0 Fixed Rates re Su220sed t0:0r6 – <nder a )xed exchange rate system

'uctuations are prevented from occurringthrough government intervention

– Fl0ating Rate System• *he supply curve of British Gounds shifts to the

right because British tastes have shifted towardincreased purchases of American goods

• *his increased supply of pound would putdownward pressure on the value of the Gound

• <nder a 'oating rate system the new lowere0uilibrium point would be reached where 0uantitysupplied of pounds e0uals the 0uantity demanded

of pounds

Example: British Pounds and US Dollar



In aC& with 'oating rates& the pound depreciatesH in bC&with pegged rates& the British central bank prevents thedecline by buying up the excess supply of pounds.




Rates

• #0 Fixed Rates re Su220sed t0 :0r6 – (Fixed Rate System)

• <nder this system& the British government would intervene

in the foreign exchange market and purchase the excesspounds available at the predetermined )xed peggedC rate

• Britain:s international reserves are used to purchase theexcess pounds which prevents the exchange rate from

falling below the pegged rate

• *raditionally these international reserves consist of gold&<.!. dollars& other ma+or currencies& and now the Euro



aC& with 'oating rates& the pound depreciatesH in bC&with pegged rates& the British central bank prevents thedecline by buying up the excess supply of pounds.



International Financial(rises• 1a+or problem with a )xed rate system is

that it contains no selfcorrectingexchange rate mechanism to eliminate acountry:s persistent balanceofpaymentde)cit

• A continual balanceofpayment de)citsuggests domestic economic structuralproblems relative to the rest of the world

• Eventually the country will run out ofinternational reserves and be forced tode1alue which will eliminate the de)cit



International Financial(rises• *he expectation of a devaluation will

cause the international )nancialcommunity to take actions that willincrease the likelihood of the anticipateddevaluation – Individuals will sell the threatened currency in

the international market

– *his increases the supply of the currency which

increases the downward pressure on the value – *his ca2ital 5ight will further deplete the

country:s international reserve and speed upthe devaluation



International Financial(rises• (urrently industrialied countries practice

a managed 50at system – *he exchange rate is permitted to vary within a

predetermined band

– If foreign exchange markets attempt to pushthe value of the currency outside the bandboth above or belowC& central bank willintervene

–

owever& if the central bank is intervening anexcessive amount& it is likely that country willbe forced to de1alue or re1alue its currencyto recognie structural changes in localeconomy

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Lecture 7_8-Flexible and Fixed Exchange Rate System

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