fixed versus flexible exchange rate arrangements
DESCRIPTION
Fixed vs. flexible exchange rate regimes. Advantages, disadvantages, the choice of exchange rate arrangement.TRANSCRIPT
Fixed vs. flexible exchange rates
Márton Zsolt
Brief historical overview
Choice of currency arrangement
Case study: China and the U.S.
How it works
How it works
Fixed exchange rate arrangement
(Scott D. L., 2003)
“
”
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.
How it works
How it works
How it works
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.
Brief historical overview
+ Appreciation of the USD
+ Massive inflation
+ Monetary shocks
+ Globalization
Transition from fixed to more flexible arrangements
Brief historical overview
In 1975, 87% of the world’s currencies were fixed.
Since then, this number has fallen well below 50%.
Why do we need fixed rates in the first place?
Choice of currency arrangement
• Gives small central banks more credibility
• Reduces volatility and sharp fluctuations in relative prices
• Eliminates exchange rate risk
• Good for exports
Some disadvantages of fixed rates:
Choice of currency arrangement
• 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
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.
Choice of currency arrangement
Advanced economies
Choice of currency arrangement
They are in the best position to enjoy flexible rates
Emerging economies
May gain from a floating system
Developing economies
Choice of currency arrangement
Can gain credibility through pegging
Essential conditions for a fixed rate:
Choice of currency arrangement
• 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)
The U.S. dollar vs. Chinese Yuan
8.27 CNY/USD peg Unofficial peg due to the crisis
June, 2010: China promises to reform its currency regime
Case study: China and the U.S.