Description
It explains fixed exchange rates, its advantages and disadvantages. How to maintain fixed exchange rates?
Exchange Rate- Fixed and Managed Float
Pegged Exchange Rate
A fixed exchange rate, sometimes 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. A fixed exchange rate is usually used to stabilize the value of a currency, against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable, and is especially useful for small economies where external trade forms a large part of their GDP. It is also used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. 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 Bretton Woods system allowed all the 44 Allied nations of World War II to fix exchange rates against the US dollar. The system collapsed in 1970.
Advantages of pegged Exchange Rate
1.
Reduced risk in international trade - By maintaining a fixed rate, buyers and sellers of goods internationally can agree a price and not be subject to the risk of later changes in the exchange rate before contracts are settled. The greater certainty should help encourage investment.
1 |Page
2.
Introduces discipline in economic management - As the burden or pain of adjustment to equilibrium is thrown onto the domestic economy then governments have a built-in incentive not to follow inflationary policies. If they do, then unemployment and balance of payments problems are certain to result as the economy becomes uncompetitive.
3.
Fixed rates eliminate destabilising speculation - Speculation flows can be very destabilising for an economy and the incentive to speculate is very small when the exchange rate is fixed.
4.
Helps reduce Inflation. If you are in a fixed exchange rate, you need to keep inflation low; otherwise the currency will start to fall below the target level. In a floating exchange rate, countries with high inflation can merely devalue, therefore there is less anti inflation discipline
Disadvantages of Fixed Exchange rate:
1. No automatic balance of payments adjustment 2. Large holdings of foreign exchange reserves required 3. Loss of freedom in your internal policy 4. Fixed rates are inherently unstable
Maintaining a fixed exchange rate
1. Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency off the market using its reserves. This places greater demand on the market and pushes up the price of the
2 |Page
currency. If the exchange rate drifts too far above the desired rate, the opposite measures are taken.
2. Another, less used means of maintaining a fixed exchange rate is by simply making it
illegal to trade currency at any other rate. This is difficult to enforce and often leads to a black market in foreign currency. Nonetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This is the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar. Throughout the 1990s, China was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the Yuan and other currencies
There are several variants of Pegged Exchange rate like-
Crawling Exchange Rate
Crawling peg is an exchange rate regime usually seen as a part of fixed exchange rate regimes which allows depreciation or appreciation in an exchange rate gradually. Some central banks use a formula which triggers a change when certain conditions are met (like need for adjustment for inflation), while others prefer not to use a preset formula and change exchange rate frequently to discourage speculations. For example, in the 1990s, Mexico had fixed its peso with the U.S. dollar. However, due to the significant inflation in Mexico, as compared to the U.S., it was evident that the peso would need to be severely devalued. Because a rapid devaluation would create instability, Mexico put into place a crawling peg exchange rate adjustment system, and the peso was slowly devalued toward a more appropriate exchange rate
Managed Float Exchange Rate
A managed floating rate systems is a hybrid of a fixed exchange rate and a flexible exchange rate system. In a country with a managed floating exchange rate system, the central bank becomes a key participant in the foreign exchange market. Unlike in a fixed exchange rate regime, the central bank does not have an explicit set value for the currency; however, unlike in a flexible exchange rate regime, it doesn’t allow the
3 |Page
market to freely determine the value of the currency. Instead, the central bank has either an implicit target value or an explicit range of target values for their currency: it intervenes in the foreign exchange market by buying and selling domestic and foreign currency to keep the exchange rate close to this desired implicit value or within the desired target values. 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.
Fig1: Exchange rate regime in 2006 Source: Wikipedia.com/exchange_rate
The Indian Aspect - Managed Float Exchange rate
India’s exchange rate arrangement is a managed float. The Reserve Bank of India (RBI), India’s central bank, emphasizes “price stability and well-anchored inflation expectations while ensuring a monetary and interest rate environment that supports export and investment demand in the economy so as to enable continuation of the growth momentum.” These objectives are implemented by adjusting market liquidity through repurchase and reverse
4 |Page
repurchase agreements, open market operations, and the cash reserve ratio applied to banks. The RBI also intervenes in the foreign exchange market to impact the nominal exchange rate, thereby providing the RBI with another tool to meet its objectives.
Conclusion:
The exchange rate in India had was fixed until the financial year 1992-1993, after which it shifted to managed float. Even after this the exchange rate market has required intervention on many occasions by the Reserve Bank of India that sold US dollars in the spot and forward markets. Prices, interest rates, and money supply in the home and foreign country are important variables to explain the behaviour of the bilateral exchange rate. Other significant variables are balance of payments items such as current and capital account balances and foreign exchange reserves. RBI intervention is necessary to keep track of two main aspects1. Smoothing excessive fluctuations in exchange rates 2. Exchange rates affect trade and aggregate demand
References: 1. MacDonald, Ronald and Jun Nagayasu. (1999) “The Long-Run Relationship Between
Real Exchange Rates and Real Interest Differentials: A Panel Study”, IMF Working Paper WP/99/37, March
2. Tarapore, S. S. (2006) Report of the Committee on Fuller Capital Account
Convertibility, Reserve Bank of India, July
3.Http://wikipedia.org/wiki/Fixed_exchange_rate 4. Determinants of Exchange Rate in India - Mita H. Suthar 5. Real Exchange Rate Stationarity in Managed Floats: Evidence from India -Renu
Kohli
5 |Page
doc_523742681.doc
It explains fixed exchange rates, its advantages and disadvantages. How to maintain fixed exchange rates?
Exchange Rate- Fixed and Managed Float
Pegged Exchange Rate
A fixed exchange rate, sometimes 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. A fixed exchange rate is usually used to stabilize the value of a currency, against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable, and is especially useful for small economies where external trade forms a large part of their GDP. It is also used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. 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 Bretton Woods system allowed all the 44 Allied nations of World War II to fix exchange rates against the US dollar. The system collapsed in 1970.
Advantages of pegged Exchange Rate
1.
Reduced risk in international trade - By maintaining a fixed rate, buyers and sellers of goods internationally can agree a price and not be subject to the risk of later changes in the exchange rate before contracts are settled. The greater certainty should help encourage investment.
1 |Page
2.
Introduces discipline in economic management - As the burden or pain of adjustment to equilibrium is thrown onto the domestic economy then governments have a built-in incentive not to follow inflationary policies. If they do, then unemployment and balance of payments problems are certain to result as the economy becomes uncompetitive.
3.
Fixed rates eliminate destabilising speculation - Speculation flows can be very destabilising for an economy and the incentive to speculate is very small when the exchange rate is fixed.
4.
Helps reduce Inflation. If you are in a fixed exchange rate, you need to keep inflation low; otherwise the currency will start to fall below the target level. In a floating exchange rate, countries with high inflation can merely devalue, therefore there is less anti inflation discipline
Disadvantages of Fixed Exchange rate:
1. No automatic balance of payments adjustment 2. Large holdings of foreign exchange reserves required 3. Loss of freedom in your internal policy 4. Fixed rates are inherently unstable
Maintaining a fixed exchange rate
1. Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency off the market using its reserves. This places greater demand on the market and pushes up the price of the
2 |Page
currency. If the exchange rate drifts too far above the desired rate, the opposite measures are taken.
2. Another, less used means of maintaining a fixed exchange rate is by simply making it
illegal to trade currency at any other rate. This is difficult to enforce and often leads to a black market in foreign currency. Nonetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This is the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar. Throughout the 1990s, China was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the Yuan and other currencies
There are several variants of Pegged Exchange rate like-
Crawling Exchange Rate
Crawling peg is an exchange rate regime usually seen as a part of fixed exchange rate regimes which allows depreciation or appreciation in an exchange rate gradually. Some central banks use a formula which triggers a change when certain conditions are met (like need for adjustment for inflation), while others prefer not to use a preset formula and change exchange rate frequently to discourage speculations. For example, in the 1990s, Mexico had fixed its peso with the U.S. dollar. However, due to the significant inflation in Mexico, as compared to the U.S., it was evident that the peso would need to be severely devalued. Because a rapid devaluation would create instability, Mexico put into place a crawling peg exchange rate adjustment system, and the peso was slowly devalued toward a more appropriate exchange rate
Managed Float Exchange Rate
A managed floating rate systems is a hybrid of a fixed exchange rate and a flexible exchange rate system. In a country with a managed floating exchange rate system, the central bank becomes a key participant in the foreign exchange market. Unlike in a fixed exchange rate regime, the central bank does not have an explicit set value for the currency; however, unlike in a flexible exchange rate regime, it doesn’t allow the
3 |Page
market to freely determine the value of the currency. Instead, the central bank has either an implicit target value or an explicit range of target values for their currency: it intervenes in the foreign exchange market by buying and selling domestic and foreign currency to keep the exchange rate close to this desired implicit value or within the desired target values. 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.
Fig1: Exchange rate regime in 2006 Source: Wikipedia.com/exchange_rate
The Indian Aspect - Managed Float Exchange rate
India’s exchange rate arrangement is a managed float. The Reserve Bank of India (RBI), India’s central bank, emphasizes “price stability and well-anchored inflation expectations while ensuring a monetary and interest rate environment that supports export and investment demand in the economy so as to enable continuation of the growth momentum.” These objectives are implemented by adjusting market liquidity through repurchase and reverse
4 |Page
repurchase agreements, open market operations, and the cash reserve ratio applied to banks. The RBI also intervenes in the foreign exchange market to impact the nominal exchange rate, thereby providing the RBI with another tool to meet its objectives.
Conclusion:
The exchange rate in India had was fixed until the financial year 1992-1993, after which it shifted to managed float. Even after this the exchange rate market has required intervention on many occasions by the Reserve Bank of India that sold US dollars in the spot and forward markets. Prices, interest rates, and money supply in the home and foreign country are important variables to explain the behaviour of the bilateral exchange rate. Other significant variables are balance of payments items such as current and capital account balances and foreign exchange reserves. RBI intervention is necessary to keep track of two main aspects1. Smoothing excessive fluctuations in exchange rates 2. Exchange rates affect trade and aggregate demand
References: 1. MacDonald, Ronald and Jun Nagayasu. (1999) “The Long-Run Relationship Between
Real Exchange Rates and Real Interest Differentials: A Panel Study”, IMF Working Paper WP/99/37, March
2. Tarapore, S. S. (2006) Report of the Committee on Fuller Capital Account
Convertibility, Reserve Bank of India, July
3.Http://wikipedia.org/wiki/Fixed_exchange_rate 4. Determinants of Exchange Rate in India - Mita H. Suthar 5. Real Exchange Rate Stationarity in Managed Floats: Evidence from India -Renu
Kohli
5 |Page
doc_523742681.doc