FIXED EXCHANGE RATE SYSTEM VS

FLOATING EXCHANGE RATE SYSTEM

Group 6

HISTORY
1821-1914 most of the World's currencies were redeemable into gold. (i.e.
you could "cash in" your paper notes for predefined weights of gold coin).
Britain was the first to officially adopt this system in 1821 and was followed
by other key countries during 1870s.
The result was a global economy connected by the common use of gold as
money.
The Bretton Woods Agreement founded a system of fixedexchangeratesin
which the currencies of all countries were pegged to the US dollar, which in
turn was based on the gold standard.
By 1970, the existingexchangerate systemwas already under threat. The
Nixon-led US government suspended the convertibility of the national
currency into gold. The supply of the US dollar had exceeded its demand.
In 1971, the Smithsonian Agreement was signed. For the first time in
exchange rate history, the market forces of supply and demand began to
determine the exchange rate.

CATEGORIES OF EXCHANGE RATE SYSTEM

1. Flexible Exchange Rate Systems

2. Fixed Exchange-rate System
3. Monetary Unions

FLEXIBLE EXCHANGE RATE SYSTEMS

The value of the currency is determined by the
market (banks, firms and other institutions)
Higher demand for a currency, all else equal,
leads to an appreciation of the currency while a
decrease in demand will lead to depreciation.
Increase in the supply of a currency, all else
equal, will lead to a depreciation of that currency
while a decrease in supply, all else equal, will
lead to an appreciation.
Most OECD countries have flexible exchange rate
systems: the U.S., Canada, Australia, Britain, and
the European Monetary Union.

MANAGED FLOATING
Afloating exchange ratein which a government
intervenes at some frequency to change the
direction
of
the
float
bybuyingorselling
currencies.
The central bank does not have an explicit set
value, it doesnt allow the market to freely
determine the value of the currency.

THE PROBLEMS OF FLEXIBLE EXCHANGE

RATE SYSTEM
The exchange rate can move for many other reasons
than changes in the domestic interest rate.
Expectations play a large role in the determination of
the exchange rate.
Flexible exchange rate may be subject to large
fluctuations which, in turn, require large movements in
the interest rate which can make the economy unstable.
Exchange rate may overshoot for a long time

FIXED EXCHANGE-RATE SYSTEM

A system whereby the exchange rates of the member
countries were fixed against the U.S. dollar, with the dollar
in turn worth a fixed amount of gold.
Governments try to keep the value of their currencies
constant against one another.
A countrys government decides the worth of its currency in
terms of either a fixed weight of gold, a fixed amount
ofanother currencyor a basket of other currencies.
Thecentral bankof a country remains committed at all
times to buy and sell its currency at a fixed price.
The central bank provides foreign currency needed to
financepayments imbalances.

HOW DOES IT WORK?

The government must buy the amount that will
bring the quantity demanded back to the original
level.
$ Price of Franc

Supply of Francs

Demand for Francs

Quantity of exchange

DE FACTO CLASSIFICATION EXCHANGE RATE

REGIMES AND MONETARY POLICY
FRAMEWORKS (IMF, 2008)
1. Exchange Arrangements with No Separate Legal
Tender
2. Currency Board Arrangements
3. Other Conventional Fixed Peg Arrangements
4. Pegged Exchange Rates within Horizontal Bands
5. Crawling Pegs
6. Exchange Rates within Crawling Bands
7. Managed Floating with No Predetermined Path for
the Exchange Rate
8. Independently Floating

EXCHANGE ARRANGEMENTS WITH NO

SEPARATE LEGAL TENDER
The currency of another country circulates as the
sole legal tender (formal dollarization)
The member belongs to a monetary or currency
union in which the same legal tender is shared by
the members of the union.
It implies the complete surrender of the monetary
authorities' independent control over domestic
monetary policy

CURRENCY BOARD ARRANGEMENTS

Exchange domestic currency for a specified foreign
currency at a fixed exchange rate, combined with
restrictions on the issuing authority to ensure the
fulfillment of its legal obligation.
Domestic currency will be issued only against foreign
exchange and that it remains fully backed by foreign
assets
Eliminates traditional central bank functions, such as
monetary control and lender-of-last-resort, and leaving
little scope for discretionary monetary policy.
Some flexibility may still be afforded, depending on how
strict the banking rules of the currency board
arrangement.

OTHER CONVENTIONAL FIXED PEG

ARRANGEMENTS
Currency is pegged at a fixed rate to another currency or a basket of currencies

The currency composites can also be standardized, as in the case of the

Special Drawing Rights (a basket of four major world currencies)
The exchange rate may fluctuate within narrow margins of less than 1
percent around a central rate-or the maximum and minimum value of the
exchange rate may remain within a narrow margin of 2 percent-for at least
three months.
The monetary authority maintains the fixed parity through direct/indirect
intervention

sale/purchase of foreign exchange in the market

aggressive use of interest rate policy
imposition of foreign exchange regulations
exercise of moral suasion that constrains foreign exchange activity

PEGGED EXCHANGE RATES WITHIN

HORIZONTAL BANDS
The value of the currency is maintained within certain
margins of fluctuation of at least 1 percent around a
fixed central rate or the margin between the
maximum and minimum value of the exchange rate
exceeds 2 percent.
There is a limited degree of monetary policy
discretion, depending on the band width.

CRAWLING PEGS
A crawling peg can be changed often (monthly,
say) according to a set of indicators or the
judgment of the countrys monetary authority.
Indicators:

The difference of inflation rates

International reserve assets
Growth of the money supply
The current actual market exchange rate relative
the central par value of the pegged rate

to

EXCHANGE RATES WITHIN CRAWLING

BANDS
The currency is maintained within certain fluctuation margins of at least 1
percent around a central rate-or the margin between the maximum and
minimum value of the exchange rate exceeds 2 percent-and the central
rate or margins are adjusted periodically at a fixed rate or in response to
changes in selective quantitative indicators.
The degree of exchange rate flexibility is a function of the band width.
Bands are either symmetric around a crawling central parity or widen
gradually with an asymmetric choice of the crawl of upper and lower bands
(in the latter case, there may be no preannounced central rate).
The commitment to maintain the exchange rate within the band imposes
constraints on monetary policy, with the degree of policy independence
being a function of the band width.

ADVANTAGES AND DISADVANTAGES OF

FIXED EXCHANGE RATE SYSTEM
Advantage

Disadvantage
1. Giving up the powerful exchange rate tool for
external stabilisation.

1. Avoid Currency Fluctuations

2. Stability encourages investment
3. Keep inflation low, joining a fixed exchange rate
may cause inflationary expectations to be lower
4. A rapid appreciation in the exchange rate will
badly effect manufacturing firms who export, this
may also cause a worsening of the current
account.

2. Sacrifice of domestic stability for external balance.

3. Gives up control of its interest rate, no
independent monetary policy
4. Widespread speculation of a devaluation or shift to
a flexible exchange rate system particularly when
Economy is with higher inflation
Or the currency is overvalued

5. Fear of Speculative attacks require an increase in

the interest rate.
6. Frequent devaluation creates uncertainty and
overvalued currency causes BOP problem.