Fixed versus flexible exchange rate arrangements
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The document provides an overview of fixed exchange rate arrangements, highlighting their historical context and the transition from fixed to more flexible exchange rates since 1975. It discusses the benefits and drawbacks of fixed rates, including their impact on credibility and volatility, as well as factors influencing currency arrangement choices among countries. A specific case study comparing the U.S. dollar and Chinese yuan illustrates the complexities of currency pegs.
Fixed versus flexible exchange rate arrangements
- 1. Márton Zsolt
- 2. How it works Brief historical overview Choice of currency arrangement Case study: China and the U.S.
- 3. How it works Fixed exchange rate arrangement “ An exchange rate between currencies that is set by the governments involved rather than being allowed to fluctuate freely with market forces. (…) authorities actively enter the currency markets to buy and sell according to variations in supply and ” demand. (Scott D. L., 2003)
- 4. How it works
- 5. How it works
- 6. How it works
- 7. Brief historical overview Bretton Woods The major currencies began to float Developing countries tried to maintain their pegs to the USD, French franc, Deutschmark, etc.
- 8. Brief historical overview + Appreciation of the USD + Massive inflation + Monetary shocks + Globalization Transition from fixed to more flexible arrangements
- 9. Brief historical overview In 1975, 87% of the world’s currencies were fixed. Since then, this number has fallen well below 50%.
- 10. Choice of currency arrangement Why do we need fixed rates in the first place? • Gives small central banks more credibility • Reduces volatility and sharp fluctuations in relative prices • Eliminates exchange rate risk • Good for exports
- 11. Choice of currency arrangement Some disadvantages of fixed rates: • Under-/overvaluation can build up and eventually lead to currency crises • Can be expensive or even impossible to hold • Black markets will emerge • Does not reflect the true value of the currency
- 12. Choice of currency arrangement Economists disagree on whether the exchange rate has a long-term effect on growth or not There is no “best answer” in all cases, every country is unique and has different needs Factors that influence the choice are: level of development, size, openness, trading partners, etc.
- 13. Choice of currency arrangement Advanced economies They are in the best position to enjoy flexible rates Emerging economies May gain from a floating system
- 14. Choice of currency arrangement Developing economies Can gain credibility through pegging
- 15. Choice of currency arrangement Essential conditions for a fixed rate: • Small and open economy • The pegged currency belongs to a large trading partner (>50% of trade) • The country wishes to pursue a macroeconomic policy that will result in an inflation rate consistent with that in the country • The country is prepared to adopt institutional arrangements that will assure continued credibility of the fixed rate commitment (Williamson, J., 1998)
- 16. Case study: China and the U.S. The U.S. dollar vs. Chinese Yuan June, 2010: China promises to reform its currency regime 8.27 CNY/USD peg Unofficial peg due to the crisis