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7/26/2019 III.fixed & Floating Rates
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Fixed Exchange Rates
vs.
Floating Exchange Rates
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Exchange Rate Regimes
What are fixed Exchange Rates?
- Officials commit to maintaining theexchange rate at a specific level.
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Exchange Rate Regimes
What are Floating Exchange Rates?
- No intervention from bankers or
government officials. The market
determines the price of the currency.
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Exchange Rate Regimes
What is a clean float? A dirty one?
- With a dirty float the government doesntpeg the currency, but tries from time to time
to influence the rate by buying or selling in
the currency markets.
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Fixed Exchange Rates
How can the government keep a currency
at a certain value if international commerce
becomes unwilling to pay that price? It cant maintain the value for long. If the
demand for the currency falls, its price
would fall as well.
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Fixed Exchange Rates
The only way the price can be kept up is for
the government promising to maintain the
original level to enter the foreign exchangemarket and bid the price of the currency
back up by purchasing it.
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Fixed Exchange Rates
The government must buy the amountthat will bring the quantity demandedback to the original level.
Quantity of exchange
$ Price of FrancSupply of Francs
Demand for Francs
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Fixed Exchange Rates
To what does the government fix the value
of its currency? When or how often does the country
change the value of its fixed rate?
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Fixed Exchange Rates
How does the government defend the fixed
value against any market pressures
pushing toward higher or lower exchange
rate value?
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Fix to what?
In the past, all currencies were fixed togold.
Today, a country can fix its value toanother countrys currency.
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Fix to what?
A country can fix its currency to abasket of other currencies.
-Same as diversifying a portfolio (Notputting all your eggs in one basket)
-Special Drawing Right (SDR)A basket offour major world currencies.
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Defending a Fixed Exchange Rate
1. To buy or sell foreign currencies (in order to
influence the prevailing exchange rate), a government
must have foreign exchange reserves.
2. It is not likely to have enough reserves to defendagainst a massive and sustained attack on the
currency. What is an attack on a countrys currency?
(Answer: Massive selling off of a currency
expected to be devalued. One can borrow theattacked currency and pay it back after devaluation.)
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Defending a Fixed Exchange Rate
How can higher i rates keep the currency value
up?
(Answer: Foreigners will purchase the nations
currency, bidding its value upward, to make
short-term investments in the country.)
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Defending a Fixed Exchange Rate
3. The government can also make long-term
adjustments of its macroeconomic
(monetary and/or fiscal policy).
Budget austerity avoids inflation and
takes downward pressure off currency.
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Defending a Fixed Exchange Rate
3. Why does inflation put downward
pressure on a countrys exchange rate?
Non-inflating countries are unwilling to pay moreand more to buy an inflating countrys goods and
services. Reduced demand for the inflating currency
will make it depreciate.
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Defending a Fixed Exchange Rate
3. Why does inflation put downward
pressure on a countrys exchange rate? Citizens of the inflating country will want to seek
bargains through imports, selling their currency to
obtain other currencies. Selling increases the supply
and drives the price down further.
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Defending The Peso Under Attack
Assume the Peso has been inflating in Mexico
Downward pressure will be on the peso. (Less
demand for it, since fewer will bepurchased with Mexican prices going up.)
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Defending The Peso Under Attack
1. The Mexican government intervenes in
currency markets, purchasing pesos to
maintain their value and promises it will
neverpermit its value to fall.
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Defending The Peso Under Attack
4. The attack will be under way if people
dont believe the promise. People sell their
pesos for dollars, etc., while the price is
still up. Note: borrow money in Mexico,change it quickly for dollars. Pay back the
loan later with cheap pesos.
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Defending The Peso Under Attack
4. The Mexican government soon runs out of
reserves and lets the peso price fall.
5. People purchase pesos back at the new,
lower rate for good gains.
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When to Change the Rate?
Why might a government want to change the
exchange value of its currency?
It might do so in order to promote, for example,greater export volume.
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When to Change the Rate?
What is a pegged exchange rate?
The termpegged exchange raterefers to setting
a targeted value for a countrys foreignexchange, and it indicates the govt. has some
ability to move the peg.
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When to Change the Rate?
Governments attempt to keep the value fixed for
relatively long periods of time to reduce trade
uncertainties.
What is an adjustable peg?
The government may change the pegged rate if a
substantial disequilibrium in the countrys
international position develops (e.g., demand for
the currency is too weak to maintain the desiredvalue).
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When to Change the Rate?
A crawling peg can be changed often (monthly,
say) according to a set of indicators or the
judgment of the countrys monetary authority.
Indicators:
The difference of inflation rates
International reserve assets
Growth of the money supply
The current actual market exchange rate relative
to the central par value of the pegged rate
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The Floating Exchange Rate
Clean Float Supply and Demand are solely
private activities
Complete flexibility
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The Floating Exchange Rate
Dirty Float (Managed Float)
From time to time, the government
tries to impact the rate throughintervention
More popular than clean float
Effectiveness of intervention iscontroversial
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To improve a poor
macroeconomic
situation, acountry increases
its money supply
so that banks are
more willing to
lend.
Interest rate
drops
Real spending,
production, and
income rise, but
Capital flows out.
(in the short run)
The Current account
balance worsens as
exports fall and importsincrease.
The overall
payments balance
worsens.
The price level
increases.
Expanding the Money Supply Worsens the Balance of Payments
Monetary Policy with Fixed Exchange Rates
M t P li ith Fl ti E h R t
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With an
increase in the
money supply,
banks are
more willing
to lend.
Interest
rate
drops
Real spending,
production, and
income rise.
Capital flows out.
(In the short run)
Current account
balance worsens.
Currency
depreciation and
automaticadjustment begins!
The Price level
increases.
Effects of Expandingthe Money Supply
The
Current
account
balance
improves
Real
product
and
income
rise more
(Beyond the short run)
Monetary Policy with Floating Exchange Rates
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In Conclusion
Fixed exchange rates are
government controlled.
Floating exchange rates are market
driven.
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In Conclusion
Governments have always preferredthe improved business climate of fixed
rates
They reduce the uncertainty ofunstable currency values (note the
European Monetary Systems fixed
rates of the 1990s).
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In Conclusion
But as financial markets havedeveloped to accommodate for flexible
exchange rates, more and more
countries have come to appreciate thevalue of market determination.
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Readings Addendum
The reading by Peter b. Kenen, fixed
versus Floating Exchange Rates is
probably expressive of a majority ofeconomists.
Once, during the era of the Bretton Woods
System, many feared floating rates. Theiruncertainty would hinder international trade
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Kenen on Fixed and Floating Rates
Times have changed since the early 1970s
and Nixons destruction of Bretton Woods.
Markets have developed to hedge exchangerisks and we have become accustomed to
the uncertainties associated with them.
Trade flourishes.
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Kenen on Fixed and Floating Rates
Fixing the exchange rate deprives a
government of two very valuable policy
instruments, the nominal exchange rate andmonetary policy, and it may therefore be
tempted to adopt beggar-thy-neighbor trade
policies to cope with output-reducingshocks.
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Kenen on Fixed and Floating Rates
Fixing the exchange rate may help stabilize
a country that has suffered extensively with
inflation. trade policies to cope with output-reducing shocks.
The commitment to a pegged exchange rate
is implicitly a commitment to monetary andfiscal stability, without which a fixed rate
cannot survive. Pegging can buy credibility.
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Kenen on Fixed and Floating Rates
When asymmetric economic shocks trouble
nations, some cannot cope without changing
their exchange rates. It is neither wise norrealistic to advocate world-wide pegging.
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Richard N. Cooper on
Exchange Rate Choices
Many countries have gone to the float for
their exchange rates, but many still decide
to peg their currency or fix their exchangerate. The choice is probably the most
important macro-economic policy decision
a country makes.
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Richard N. Cooper on
Exchange Rate Choices
Cooper reviews the international monetary
experience among the major countries,
reviewing the reasons why floating rateswere long viewed with suspicion.
He discusses the Friedman/Johnson case for
flexible rates made in the sixties andseventies. Johnson thought the developing
countries would continue to peg their rates.
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Richard N. Cooper on
Exchange Rate Choices
Cooper reviews the potential pitfalls for
developing countries when international
institutions insist that they both move togreater exchange rate flexibility and to
liberalize international capital movements at
the same time.
Ri h d N C
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Richard N. Cooper on
Exchange Rate Choices
Flexible exchange rates have worked very
well for the leading industrial countries. It
will be interesting to see how Europe fareswith absolutely fixed exchange rates among
EU members (via the Euro) and how the
Euro/U.S. Dollar relationship develops.
Ri h d N C
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Richard N. Cooper on
Exchange Rate Choices
Were still learning, but movements in
exchange rates provide a useful shock
absorber for real disturbances to the worldeconomy, but they are also a significant
source of uncertainty for trade and capital
formation, the wellsprings of economicprocess.