Fixed and Floating Currencies
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1. Countries have a choice between fixed exchange rate systems, where a currency's value is pegged to another currency or basket of currencies, and floating exchange rate systems, where a currency's value is determined by market forces. 2. With a fixed exchange rate, a central bank must intervene in currency markets to maintain the peg, while with a floating rate the central bank may intervene occasionally but does not target a specific exchange rate. 3. The main options for exchange rate systems are free floating, where markets wholly determine the currency's value; managed floating, where a central bank can intervene to meet economic objectives; and fixed rates like a currency peg or membership in ERM II aiming to join the Euro.
Fixed and Floating Currencies
- 1. Revision on Fixed and Floating Exchange Rate Systems
- 3. Revision MC (1) Euro 1 buys 82.8 pence 82.8 pence = $1.375 £1 = $1.375/0.828 = $1.66
- 7. Trade weighted exchange rate index New index = (110x80) + (150x20) / 100 (8800 + 3000) = 11800 / 100 = 118 Revision MC (3)
- 10. Classification of Currency Systems • The choice of exchange rate regime is one of the most important a country can make as part of monetary policy. The main options are: 1. A free-floating currency where the external value of a currency depends wholly on market forces of supply and demand 2. A managed-floating currency when the central bank may choose to intervene in the foreign exchange markets to affect the value of a currency to meet specific macroeconomic objectives 3. A fixed exchange rate system e.g. a currency peg either as part of a currency board system or membership of the ERM II for countries intending to join the Euro.
- 11. Classification of Currency Systems (December 2016) Exchange Rate System Exchange rate anchor (where relevant) US Dollar ($) Euro Composite or Other Currency Peg Fixed currency with no separate legal tender Ecuador Zimbabwe Kosovo, San Marino Currency Board System Hong Kong Bulgaria Conventional exchange rate peg (fixed currency system) Bahrain Qatar Saudi Arabia Denmark Senegal Kuwait Nepal Crawling exchange rate peg (semi-fixed currency) Jamaica Croatia Botswana China Ethiopia Managed floating currency Kenya, Brazil, Ukraine, South Korea, India, Zambia, South Africa, Thailand, Turkey, Sweden, Mexico, Israel, Japan, Chile Free floating exchange rate Australia, Canada, Norway, UK, USA, Euro Zone
- 12. Denmark operates fixed exchange rate against Euro
- 13. Poland operates floating exchange rate against Euro
- 14. Free Floating Exchange Rates • The strength of currency supply and demand drives the external value of a currency in the markets Currency value set by market forces • Central bank allows the currency to find its own level No intervention by the central bank • External value of currency is not used as an intermediate target of macroeconomic policy No target for the exchange rate
- 15. Sterling Exchange Rate (as an index number) 70.0 75.0 80.0 85.0 90.0 95.0 100.0 105.0 110.0 115.0 120.0 02Jan14 02Feb14 02Mar14 02Apr14 02May14 02Jun14 02Jul14 02Aug14 02Sep14 02Oct14 02Nov14 02Dec14 02Jan15 02Feb15 02Mar15 02Apr15 02May15 02Jun15 02Jul15 02Aug15 02Sep15 02Oct15 02Nov15 02Dec15 02Jan16 02Feb16 02Mar16 02Apr16 02May16 02Jun16 02Jul16 02Aug16 02Sep16 02Oct16 UK Exchange Rate Indices, 2nd Jan 2014 = 100 Sterling ERI €/£ $/£ Source: Bank of England
- 16. The June 2016 Post-Brexit Sterling Depreciation Daily post-Brexit currency exchange rates of Sterling (GBP) against the Euro (EUR) June 2016 1.15 1.17 1.19 1.21 1.23 1.25 1.27 1.29 1.31 1.33 June20 June21 June22 June23 June24 June27 June28 June29 June30 July1 July4 July5 July6 July7 July8 July11 July12 July13 July14 July15 July18 July19 July20 July21 Exchangerate Sterling depreciated against the Euro following the Brexit vote. From £1 buying Euro 1.31, the pound slipped to £1 buying Euro 1.17 before stabilizing. Remember: • A depreciation happens inside a floating exchange rate system • A devaluation happens with a fixed exchange rate system
- 18. Currency Crisis - Turkey • Political instability (failed coup in 2016) • Large current a/c deficit • Investors get nervous – capital flight intensifies • Country exposed to existing external debts • More expensive to repay when the value of the currency falls • Limited impact of central bank intervention • Higher interest rates risk causing a deep recession
- 19. Fixed Exchange Rates • External value is pegged to one or more currencies • The central bank must hold sufficient foreign exchange reserves in order to intervene in currency markets to maintain the fixed peg Government / central bank fixes currency value • Trade takes place at this official exchange rate • There might be unofficial trades in shadow currency markets Pegged exchange rate becomes official rate • Occasional realignments may be needed • E.g. a devaluation or revaluation depending on economic circumstances – the currency may have drifted from fundamental value Adjustable peg
- 21. Managed Floating Exchange Rates • Central bank gives a degree of freedom for market exchange rates on a day-to-day basis Currency usually set by market forces • Buying to support a currency (selling their FX reserves) • Selling to weaken a currency (adding to their FX reserves) • Changes in policy interest rates to affect “hot money flows” Central bank may intervene occasionally • Higher exchange rate to control inflationary pressures • “Competitive devaluation” to improve competitiveness Currency becomes a key target of monetary policy
- 22. Tools for Managing Floating Exchange Rates • Changes in interest rates e.g. lower interest rates to depreciate the exchange rate • Causes movements of “hot money” banking flows into or out of a country Changes in monetary policy interest rates • Increase liquidity in the banking system, usually causes outflow of money – depreciation of the exchange rate Quantitative easing • Direct intervention in the currency market • Buying and selling of domestic / foreign currencies Direct buying / selling in the currency market (intervention) • Taxation of foreign deposits in banks cut the profit from hot money inflows • Controls on the free flow of capital into and out of a country Taxation of overseas currency deposits and capital controls
- 24. Evaluating Floating Exchange Rates Floating Exchange Rates •Reduces need to hold large currency reserves •Freedom to set interest rates to meet domestic objectives •Insulation for an economy after an external shock especially for export- dependent countries •Partial automatic correction for a current account deficit •Less risk of a currency becoming significantly over/undervalued Evaluation • No guarantee that floating exchange rates will be stable • Volatility in a floating exchange rate might be detrimental to attracting inward investment • A lower (more competitive) exchange rate does not necessarily correct a persistent balance of payments deficit - consider the J curve theory and also the importance of non-price competitiveness
- 25. Evaluating Fixed Exchange Rates Fixed Exchange Rates • Certainty of currency value gives confidence for inward investment • Reduced costs of “currency hedging” for businesses • Stability helps to control inflation – i.e. it is a discipline on businesses to keep their unit labour costs low • Can lead to lower borrowing costs (i.e. lower yields on bonds) • Imposes responsibility on government macro policies • Less speculation if the fixed exchange rate is credible Evaluation • Reduced freedom to use interest rates for other macro objectives • Many developing countries do not sufficient foreign currency reserves to be able to maintain a fixed exchange rate • Difficult for countries to use a competitive devaluation of their fixed exchange rate - creates political tensions and might lead to a protectionist response • Devaluation of a fixed exchange rate can lead to a surge in cost-push inflation - damaging for competitiveness and has regressive effects on poorer families
- 26. @tutor2ugeoff
- 27. Revision on Fixed and Floating Exchange Rate Systems