Fixed Versus Floating Exchange Rate System

An exchange rate is the price’s rate at which one countrys currency trades for another on the foreign exchange market. This rate differs from country to country and it is depends on many economical variables, the main of which are the general balance and imbalance of economy, monetary and fiscal policy, the state of the budget, international policy, the condition and development of the country’s economy compared to the world situation and dominating countries, purchasing power of the currency, and other internal and external factors.

Based on the internet that we found on internet, the history of world exchange rate systems shows us that the world community which in its majority has in fact shifted from the system of fixed exchange rates to floating exchange rate system. According to the information, there exist different combinations of floating and fixed exchange rate systems currently, together with specific economical instruments, these systems were created for exchange rate regulating. There are 2 extreme regimes of exchange rates which are floating exchange rate and fixed foreign exchange rate.

The fixed exchange rate system is the system in which the value of a countryHYPERLINK “http://www.businessdictionary.com/definition/country.html”‘HYPERLINK “http://www.businessdictionary.com/definition/country.html”s currency, in relation to the value of other currencies, is maintained at a fixed conversion rate through government intervention. Fixed exchange rate is opposite of floating exchange rate.

Government used the fixed exchange rate system to fix the exchange rate and this system is included two exchange rates, which are fixed and unconvertible exchange rate and fixed and convertible exchange rate.

The value of the currencies for the flexible exchange rate system are free to change in relation to one another according to market demand and supply for each currency .The flexible system are widely used in many countries of the world. Some common examples of the flexible exchange rates would be the British pound, United States dollar, Japanese Yen and Euro. The main factors affecting the flexible exchange system are trade flows and capital flows. The government and or monetary authorities can adjust the interest rates for domestic economic purposes rather than to achieve a given exchange rate target. Other than that, undergo shows that flexible exchange rates are more resilient in the face of shocks, and are better able to distribute the burden of adjustment between the external sector and the domestic economy.

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Background Studies

Nineteenth century, from 1876 to 1913, the exchange rate system was dependent on the exchange rates between different countries equaled to the ratio of gold content linked with the currencies (The gold standard) but this method of determination of the exchange rate had to be reassessed when the gold standard was suspended during World War I because the economies of the countries with less credible currencies have been affected by such attacks, and the state of these economies has worsened. This situation has shown one of the weaknesses of the gold standard.

From 1914 – 1944, the suspension of the gold standard in 1914 was followed by a collapse of the exchange rate market. In the early 1920s, some countries tried to use again the gold standard to get the old exchange system back into practice. However, the Great Depression hit the United States in 1929. The shocking effects of this were felt by most of the developed world. As a result, all plans on the revision of the gold standard were abandoned.

After World War II the major countries adopted the Bretton-Woods system. The impact of the Great Depression was still fresh in the minds of the policymakers, they wanted to shun all possibilities of a similar fiasco. The Bretton Woods Agreement founded a system of fixed exchange rates in which the currencies of all countries were pegged to the US dollar, which in turn was based on the gold standard.

From 1944 – 1971, the Bretton Woods Agreement was in effect till 1971. By 1970, the existing exchange rate system was already under threat. The Nixon-led US government suspended the convertibility of the national currency into gold. The supply of the US dollar had exceeded its demand. In 1971, the Smithsonian Agreement was adopted. For the first time in exchange rate history, the market forces of supply and demand began to determine the exchange rate.

Close to the end of World War II, the Bretton Woods Agreement was signed. They wanted to shun all possibilities of a similar fiasco, since the impact of the Great Depression was still fresh in the minds of the policymakers. The Bretton Woods Agreement founded a system of fixed exchange rates in which the currencies of all countries were pegged to the US dollar, which in turn was based on the gold standard

The Smithsonian Agreement did not effective very long. In 1973, the widely traded currencies were allowed to fluctuate; the floating exchange system was introduced. In a floating exchange system, a currency’s value is allowed to vary in keeping with the conditions of the foreign exchange market match with equilibrium.

Literature Review

Flexible exchange system and flexible exchange rate determined by 3 factors:

R. J. Barry Jones examined the first factor is the price level abroad and at home. When the price of the goods made in home country fall relative to goods made in country abroad may affect the home country currency appreciate.

Second, real factors related to trade flow (R. J. Barry Jones, 2001). For example, the depreciation of the exchange rate of local currency through capital outflow makes local goods cheaper compared to foreign goods and increases export and decreases import.

And the third factor is international capital flows. Thomas Long examined increasing interest rates, the returns available to those who invest in that country increase. When there is an increase of demand for that currency as investors invest where the interest rates are higher. Countries will offer the highest return on investment through high interest rates, economic growth, and growths in domestic financial markets tend to attract capital from abroad countries. If a country’s stock market is doing well, and they offer a high interest rate, foreign investors are likely to invest capital to that country. This may increases the demand for the country’s currency, and causes the currency’s value to rise.

Advantages and disadvantages of fixed exchange rate system

Fixed exchange rates stimulate international trade and offer much greater stability for the enterprisers. Since the exchange rates stay on the equivalent level, the importers and exporters can plan their policy without begin afraid of depreciation or appreciation of the currency.

Furthermore, fixed exchange rates make the producers more disciplined. This is because the producers are forced to keep up with the quality of their production and to control the costs of the production to stay competitive compared to international enterprisers and this advantage of fixed exchange rates allows the government to decrease inflation level and stimulate international trade and economical growth in the long period.

Besides, fixed exchange rates stimulate the reduction of speculative activity worldwide based on the statement under the condition that the adopted exchange rates are profitable for the foreign dealers as well as for domestic ones.

Based on the journal Exchange Rate Systems in Perspective by Alan C. Stockman, Alan said that with the dominant money demand shocks, the fixed exchange rate system supposed to be better than flexible system. This is because the money supply automatically adjusts to change in money demand without requiring interest rate changes or price level changes and the various short-run disruptions that can result when nominal price levels respond sluggishly. But Alan also said that the floating exchange rate system is supposed to be better compare to fixed rate system when the dominant shocks are real because under the floating rate system the exchange rate can be adjusted.

As Anatolie Marie Amvouna stated in her report (Determinants of Trade and Growth Performance in Africa), variants of the floating exchange rate regime are more common among the leading industrial countries while fixed exchange rate regimes are mainly found among the developing countries. In many developing countries, there are lack of outside market for their domestic currencies, and their internal capital market are weak (Helmers,1988).

According to Shu Wei Wong (Oct 09, 2007) under the fixed exchange rate system, a decrease in the exchange rate which is infrequent are called revaluations. While an increase in the exchange rate are called devaluations. A devaluation in a fixed exchange rate will cause the current account balance to rise, making a country’s export less expensive for foreigners and also discourage import by making import products more expensive for domestic consumers,. This will leads to an increase in trade surplus or a decrease in trade deficit. The opposite happens in a revaluation.

The high vulnerability of the economical system to speculative attacks is the main disadvantages of the fixed exchange rate system. This is because the fixed rate needs to be changed if and if the national banks are unable to cover the gap between the existing resources and demand or any economy experiences excess supply and demand in either national or foreign currency and this situation will reduce the positive effects of the fixed rate exchange system and decreases the credibility of the currency.

Another disadvantage of this system is the development of the country’s economy is not as efficient as it could be if the rate was adjusted to the situation if government artificially supports the exchange rate, which is not adjusted to changed economical condition. Moreover, interest rates will directly depend on the exchange rate, and it can stop possible economical growth in case of their disparity to market needs.

Advantages and disadvantages of floating exchange rate system

Richard E.Caves examined the major advantage of this system is its flexibility and the possibility for the country’s economy to fluctuate in response to changing market conditions and lets it move freely to the equilibrium of demand and supply. Pedro-Pablo Kuczynski Godard, John Williamson (2003) illustrate this further, consider Japan inflation increase faster than its trading partners, the products will become more expensive abroad and this may lead to decrease in demand for Japan goods, services, and therefore for yen. This will also affect the value of the currency fall, which will make the export become cheaper, which will offset the higher inflation or make import relatively expansive. The needed nominal exchange rate depreciation to correct for the shock will be lower the more open and trade diversified economy.

If the balance of payments deficit is violated, the floating exchange rate system allows to adjust a currency outflow or inflow into the country; this automatically makes the domestic goods more competitive (in case of appreciation on the currency market) or makes foreign goods more competitive (in case of the currency’s depreciation).

While, based upon research ,the second advantage of floating exchange rate system is useful instrument of macroeconomic adjustment a flexible rate can be a useful tool for macroeconomic adjustment – for example depreciation will affect the net export demand increase and stimulate the growth (Geoff Riley,2006). Md. Rafayet Alam examined fact in the era of devaluation the authority in Bangladesh, like in many third world countries, used to place export as one of the foremost reasons of devaluing local currency against US$. In this analysis, the result shows that no causality runs from depreciation of real exchange rate of Taka to export earning of Bangladesh. Floating exchange rate system reduced risk of currency speculation. The absence of an explicit exchange rate target reduces the risk of currency speculation. Often, currency market speculators target an exchange rate target that they believe to be fundamentally over or undervalued (Geoff Riley, 2006). Besides, Pierre-Richard Agénor examined the advantages of this system include no cost intervention. The government will not use the resources to buy or sell the currency and this enables the government more focus on the domestic economy issues.

Andrew Gillespie examined the value of the currency will varies regularly, these affect the firm difficult to plan ahead. For example, Europe will not know the actual price of their product will be oversea buyers at any moment. Europe importers will not know what they have to pay to buy the foreign goods. This affects the planning ahead very difficult. Other than that, Andrew Gillespie also examined that the value of the currency unpredictability may harm to the export, and the import-competing. This may leads to resources being invested in other country.

Next, the exchange rate under flexible exchange system may not able to increase and decrease to meet the equilibrium point. For example, if the supply curve is downward sloping, the currency of the market is not able to meet equilibrium (Andrew Gillespie, 2007).

As figure 1 shows, moving away from the equilibrium when the supply of the currency is downward sloping. Besides, the demand and the supply condition are change all the time, this may make the value of the currency varies easily. This will encourage speculation. But this will affect the change of the buying and selling of currency, this leads to greater instability.

Figure 1

Exchange rates under fixed and floating regimes

With floating exchange rates, changes in market demand and market supply of a currency cause a change in value. In the diagram below we see the effects of a rise in the demand for sterling (perhaps caused by a rise in exports or an increase in the speculative demand for sterling). This causes an appreciation in the value of the pound. Changes in currency supply also have an effect. In the diagram below there is an increase in currency supply (S1-S2) which puts downward pressure on the market value of the exchange rate.

Supporting Theory

The starting point of exchange rate theory is purchasing power parity (PPP), which is also called the inflation theory of exchange rates. Purchasing power parity theory was first presented to deal with the price relationship of the value of different currencies with the good. It’s requires very strong pre-conditions.

Generally, PPP theory holds in an integrated, competitive product market with the implicit assumption of a risk-neutral world, in which the goods can be traded freely without transportation costs, tariffs, and export quotas. However, it is unrealistic in a real society to assume that no costs are needed to transport goods from one place to another. This is because each economy produces and consumes tens of thousands of commodities and services, which have different prices from country to country because of transport costs, tariffs, and other trade barriers. PPP theory is generally viewed as a condition of goods market equilibrium, both the home and foreign market are integrated into a single market.

Exchange rate system was also closely related to monetary policy and both are generally dependent on many of the same factors. Monetary policy uses a variety of tools to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. A central bank can only operate a independent monetary policy when the exchange rate is flexible. Central bank will have to purchase or sell foreign exchange, if the exchange rate is pegged or managed in any way. These transactions in foreign exchange will have an effect on the monetary base analogous to open market purchases and sales of government debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a pure floating exchange rate, central banks and monetary authorities can at best “lean against the wind” in a world where capital is mobile.

The exchange rate will influence home country monetary conditions, to retain its monetary policy target; the central bank has to offset its foreign exchange operations. For example, if a central bank buys foreign exchange (to offset appreciation of the exchange rate), base money will increase. Therefore, to sterilize that increase, the central bank must sell the government debt to contract the monetary base by an equal amount. It follows that turbulent activity in foreign exchange markets can cause a central bank to lose control of home country monetary policy when it is also managing the exchange rate.

Conclusion

The fixed exchange rates are theoretically feasible but this does not mean they are politically acceptable. Under fixed rates, the country with the fastest growing money supply gets the most revenue from money creation. More important, some of this revenue is collected from residents of other countries. With fixed exchange rates, the inflation caused by one country’s money growth is experienced by residents of all countries. This outcome is caused to be politically unacceptable to other countries.

A country can prevent another country from exporting inflation by letting its own exchange rate appreciate. As a result, countries will not stick to fixed rates unless they are willing to coordinate their monetary policies.

The fixed exchange rate regime is still used for several reasons because with the certainty in fixed exchange rate, international trade and investment becomes less risky. Besides, there is little or no speculation on a fixed exchange rate.

While a floating regime is not without its flaws, and it has proved to be a more efficient means of determining the long-term value of a currency and creating equilibrium in the international market.

In general, a fixed exchange rate is preferable if the disturbances impinging on the economy are pre-dominantly monetary. For example, the changes in the demand for money and thus will affect the general level of prices. Unlike the fixed exchange rate, a flexible is preferable if disturbances are predominantly real. For example, the changes in tastes or technology that affect the relative prices of domestic goods or its originate abroad.

As a conclusion, although fixed exchange rate regime is still used, but if compare to floating exchange rate system, the latter which is floating exchange rate system have a strong advantage over fixed exchange rate system. This will be shown in the absence of common currencies.