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fixed exchange rate

Page history last edited by Brian D Butler 15 years, 1 month ago

Fixed exchange rate

 

 

A fixed exchange rate, sometimes (less commonly) called a pegged exchange rate, is a type of exchange rate regime wherein a Currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold. As the reference value rises and falls, so does the currency pegged to it. A currency that uses a fixed exchange rate is known as a fixed currency. The opposite of a fixed exchange rate is a floating exchange rate.

 

 

Table of Contents:


 

 

 

 

see also Currency

 

 

Countries fight currency appreciation...

 

Yes, China manipulates its currency. Arguably, so do Singapore, Argentina, Saudi Arabia and any nation that either pegs its currency, maintains a tight trading band or oversees a “managed float” system. Even Hong Kong, routinely ranked as the world’s freest economy by the Heritage Foundation, manipulates its currency. It has to maintain its link to the U.S. dollar.

 

seee more about fixed exchange rate

 

 

 

Good, Bad and Ugly of fixed FX rates...

 

see also global imbalances (finance)

 

 

Many economists think that in most circumstances, floating exchange rates are preferable to fixed exchange rates because floating rates are responsive to the foreign exchange market. In addition, fixed exchange rates deprive governments of the use of an independent domestic monetary policy to achieve internal stability. However, in certain situations, fixed exchange rates may be preferable for their greater stability. For example, the Asian financial crisis was improved by the fixed exchange rate of the Chinese renminbi, and the IMF and the World Bank now acknowledge that Malaysia's adoption of a peg to the US dollar in the aftermath of the same crisis was highly successful. Following the devastation of World War II, the Breton Woods allowed Western Europe to have fixed exchange rates until 1970 with the The US Dollar

 

Yet others argue that the fixed exchange rates (implemented well before the crisis) had become so immovable that it had masked valuable information needed for a market to function properly. That is, the currencies did not represent their true market value. This masking of information created volatility which encouraged speculators to "attack" the pegged currencies and as a response these countries attempt to defend their currency rather than allow it to devalue. These economists also believe that had these countries instituted floating exchange rates, as opposed to fixed exchange rates, they may very well have avoided the volatility that caused the Asian financial crisis. Countries like Malaysia adopted increased capital controls believing that the volatility of capital was the result of technology and globalization, rather than fallacious macroeconomic policies which resulted not in better stability and growth in the aftermath of the crisis but sustained pain and stagnation.

 

Countries adopting a fixed exchange rate must exercise careful and strict adherence to policy imperatives, and keep a degree of confidence of the capital markets in the management of such a regime, or otherwise the peg can fail. Such was the case of Argentina, where unchecked state spending and international economic shocks disbalanced the system and ended up forcing an extremely damaging devaluation (see Argentine Currency Board, Argentine economic crisis, and the Mexican peso crisis). On the opposite extreme, the People's Republic of China's fixed exchange rate with the US dollar until 2005 led to China's rapid accumulation of foreign reserves, placing an appreciating pressure on the Chinese yuan.

 

 

Good things:

  • more stability (less volatility)
  • more international confidence
  • leads to more international trade
  • some economists claim that a common currency area, such as the Euro has led to lower levels of inflation, and lower interest rates (the lower inflation claim is highly debated...is it cause and effect?  or, pure coincidence?)

 

Bad things:

  • In a free floating regime, there is no way for a country to have a balance of payments crisis because the Currency will adjust.  But when the currency fixed, or pegged to another currency, it is possible to have a BOP crisis (think "tequila crisis" in Mexico).
  • the Euro zone has seen lower GDP growth than the UK  (which did not join the Euro) since its adoption.  Also, the UK has seen lower levels of unemployment.  Did the adoption of the common currency lead to a lower growth and higher unemployment?  This topic is highly debated by economists. 

 

 

 

 

 

Future :  fix again?

 

possibility of a new Transatlantic currency. When I mention this possibility, everyone laughs, but think about it for a second. The economic crisis on both sides of the Atlantic is enormous. Both are resorting to the same formulas – large fiscal stimulus and quantitative easing

 

see: "interestng conclusion" below...

 

 

Past:

Breton Woods

  • led to creation of IMF and the World Bank
  • monetary....led to a system of fixed exchange rates
  • failed because US was printing too much USD. Other countries wanted to exchange for too much gold, more than the US had.
  • Us inability to support dollar by supplying gold...led to break down

 

The Gold Standard

  • lasted for 60+ years
  • countries fixed their currency exchange rate with gold
  • central banks held gold reserves
  • if a country imported more than exported, then there would be more of your currency in the market than what foreigners wanted to hold.  The exporter wouldn't want your currency, so he would sell it to a bank, who would sell it to a central bank, who also wouldn't want it...so they would come back to your country and ask to exchange it for gold.  Your country would need to give gold, reducing your supply of gold.  Then, according to the rules, your country would also have to reduce its money supply so that the ratio of money to gold was maintained.   With less money in the system, prices would fall (see discussion of inflation).  Once this reverse-inflation occurred, and prices fell, then exports would increase, and imports would decrease. This would take the country back to a trade balance. 
  • The trouble is that this process takes a very long time, and is very painful to the economy.

 

Competitive Devaluations

  • but, after WWI, there were competitive devaluations in the 1930's which led to WWII - "beggar thy neighbor"
  • there was a "floating system" during the great depression.
  • was not fixed because was too expensive to maintain.
  • at the end of WWII (before it ended), the Allied powers met at Bretton Woods (in the US) and agreed to a fixed exchange rate policy

 

Bretton Woods

The US was the only major super-power after WWII with an intact economy

so, the US would do what gold had done before...and all currencies would be fixed to the US dollar

fort knox (gold)

 

 

End of Bretton Woods

  • 1973 - the US was forced to break the fixed exchange system
  • not enough gold
  • affected all other currencies
  • but, why did it fail?
  • excess demand for gold
  • US was printing too much dollars to support with gold
  • spending too much on VIETNAM war (this was the major reason)
  • world lost confidence in US ability to support gold standard...led to run on gold
  • the result was a balance of payments crisis

 

Interesting conclusion:

  • no FX regime (currency exchange system) has ever lasted more than 75 years.
  • no system is best.
  • the USA has gone from fixed to floating to fixed, and back to floating.
  • sometimes fixed is better, sometimes flexible

 

 

Why be fixed / floating?

 

Sometime there is no choice, and a country must be floating.  Why?...There is one theory that lays out the trade-off that nations face when selecting their important policy decisions.  Specifically, it has an impact on their abilty to control their currency exchange rate.   The Mundell Trilemma states that if a country like the USA wants to have domestic control of its interest rates (monetary policy), and if they also want to have access to free flow of capital internationally (no capital controls), then they must have a free floating exchange rate:

 

 

The Mundell Trilemma

 

basically says that a country can not have control of their currency if they want to (a) control their domestic interest rates, and (b) have free flowing capital into and out of the country.

 

A country basically has to choose 2 out of 3 of the following options. (#1). The first option is for control over their currencies exchange rates. A country might want to have a stable currency (and not one that fluctuates greatly) . This is especially important for countries that have a high percentage of foreign trade (in relation to their GDP) and that want to be able to predict the level of trade from one term to the next.

 

This is the option that the USA (and Europe, and Japan) have chosen to give up, in an effort to maintain options #2 and #3 (described below). The US has essentially been forced to allow their currency to “float” in the foreign exchange markets and be determined purely by global supply and demand of their currency. The advantage of this system is that it allows you to maintain internal domestic control over your economy (by being able to raise and lower interest rates), and it also allows you to take advantage of the massive movement of global financial capital. The drawback of selecting this free-floating exchange rates system is that you can have a relatively cheap currency one year, and thus a favorable environment for exports, but then have a relatively expensive currency the following year (and a favorable environment for imports). It makes international business difficult to plan from one year to the next because you never know if your products are going to be cheap or expensive on the world markets.

 

 

(#2). The second part of the “Mundell trilemma” is domestic macro-economic control. A country might want to have the ability to raise internal interest rates in order to fight inflation, or lower interest rates to promote growth. This ability of the national government to control the rates of growth, unemployment and inflation is critical in countries that have a democracy, and where the elected officials are dependant upon the approval of the population.

 

This is the one option that Argentina chose to give up in 1991 when they pegged their currency to the US dollar. By choosing both option #1 (fixed exchange rates) and option #3 (free mobility of capital), the Argentineans were forced to give up on option #2 (domestic control over interest rates, inflation, and economic growth). The benefit of choosing this option (as Argentina did) is that if a country has a track record of internal corruption, and therefore has a bad reputation among the global financial traders, they might have a difficult time attracting foreign capital (because investors are afraid of corruption, inflation, and so on). But, by tying their currency to a “hard currency” such as the USD, it allows a country to gain instant credibility in macroeconomic management.

 

The major drawback of this system is that a country loses the ability to raise or lower internal interest rates. Because a country has tied their currency to another “hard currency” such as the USD, then the country must keep their interest rates in line with those of the USA, for example. If there is a divergence in rate, then traders could step in and take advantage of the arbitrage (buying in one country, and selling in another to profit the difference). The global financial markets are too powerful to try and fight, so in the end, the county with the pegged currency is forced to follow the interest rate lead of the hard currency. But, what happens if country with the peg needs to lower interest rates in order to spur growth? They can’t. What if they want to raise interest rates to cut inflation? They can’t.

 

(#3). The third option is to have international capital mobility. Some countries will find it essential that they have access to global financial capital flows. The USA and Japan for example, are very dependent upon the free flow of capital in and out of their countries in order to finance from and invest abroad (and maintain their large balance of payments). During the Bretton Woods years (1947-71), the US had a different system in that they had selected to maintain #1 (fixed exchange rates), and option #2 (control over domestic policies such as interest rates), but chose to abandon the principle #3 (free flowing international capital). In fact, the entire world chose to limit the flow of international capital for fear of repeating the same dangerous mix that had occurred in lead up to the war.

 

Even today, there are many countries that would like to limit or control the flow of financial capital into and especially out of their country. Thailand recently attempted to instill financial controls. Why? Well, because the county is alarmed with the level and speed with which financial capital can leave their countries, and leaving a financial crisis in its wake. Many countries are alarmed with the level of speculation that occurs in the global FX market, and they would like to have a way to limit their exposure to the speculative risk. The problem is that in order to protect themselves fro the quick movement of financial capital, they must first be willing to give up on either (#1) a fixed and stable exchange rate, or (#2) the domestic control of their international interest rates.

 

 

How the Mundell Trilemma effect currency trading?

 

It relates to the forward exchange rate / futures contracts.  If a country is going to have interest rates that are different, then they must allow the forward contract to have appreciation/ depreciation to prevent arbitrage.  (as long as money is free to flow into / out of the country).

 

 

 

 

 

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