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floating exchange rate

Page history last edited by Brian D Butler 13 years, 7 months ago

 

 

 

 

 

Table of Contents:


 

 

Floating Exchange rate 

 

A floating exchange rate or a flexible exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. The opposite of a floating exchange rate is a fixed exchange rate as we saw with the Breton Woods fixed rates system up until 1973. 

 

 

Good things about Floating rates

 

  • 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).

 

 

Benefits of Floating Exchange 

 

Many economists think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. They allow the dampening of shocks and foreign business cycles. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. This may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency "strong" or "high" relative to others, such as the UK or the Southeast Asia countries before the Asian currency crisis.

 

There is no currency in the world whose value is absolutely and entirely determined by the foreign exchange market, except for Canada or possibly the United States; in cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by the central bank may take the form of buying or selling large lots in order to provide price support or resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds.

 

 

Bad things:

  • Volatility
  • lack of confidence of importers/ exporters ...if they think the currency can fluctuate widely, they may be less willing to infest FDI in your country.  Uncertainty = risk
  • leads to less international trade
  • in response to these weaknesses, Milton Friedman proposed introducing contracts - Forward, and Futures contracts (see Futures market and forward exchange rate discussions), which the world adopted in 1973, the same year that Bretton Woods failed.

 

 

Fear of Floating rates

 

A free floating exchange rate increases foreign exchange volatility. This may cause serious problems, especially in emerging economies. These economies have a financial sector with one or more of following conditions:

  • high liability dollarization
  • financial fragility
  • strong balance sheet effects

 

When liabilities are denominated in foreign currencies while assets are in the local currency, unexpected depreciations of the exchange rate deteriorate bank and corporate balance sheets and threaten the stability of the domestic financial system.

 

For this reason emerging countries appear to face greater fear of floating, as they have much smaller variations of the nominal exchange rate, yet face bigger shocks and interest rate and reserve movements (Calvo and Reinhart, 2002). This is the consequence of frequent free floating countries' reaction to exchange rate movements with monetary policy and/or intervention in the foreign exchange market.

 

According to data from Levy-Yeyati and Sturzenegger (2004), the number of countries that present fear of floating increased significantly during the nineties

 

 

 

Theory:  How FX rates should adjust with import/ export imbalances:

 

  • if a country imported more than exported, then there would be more of your currency in the market than what foreigners wanted to hold.  Supply of a currency would be >  demand of currency...so the value of the currency in the market should go down
  • if the value of the currency goes down, then exports increase and demand for the currency picks up
  • this continues until equilibrium
  • Milton Friedman was excited about the possibility of a floating exchange rate, and advocated for the end of Bretton Woods (for more info:  http://en.wikipedia.org/wiki/Milton_Friedman).  He argued that countries with excess imports would have their currency devalued (see mechanism discussed above), and that the FX rate would drop, causing the country to import less and export more, until equilibrium was achieved.
  • The problem with Milton Friedmans prescription is that the US has had 30+ years of excess imports over exports (ever since Bretton Woods ended), and the currency has never fully adjusted to remove this imbalance/
  • The reason for this continued imbalance in the "current account" is that the US has also continuously had a surplus in the "Capital Account" (see discussion in balance of payments ).

 

 

 

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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