Transcript Fixed Exchange Rate - BYU Marriott School

Fixed Exchange Rates
vs.
Floating Exchange Rates
Exchange Rate Regimes
What are fixed Exchange Rates?
- Officials commit to maintaining the
exchange rate at a specific level.
Exchange Rate Regimes
What are Floating Exchange Rates?
- No intervention from bankers or
government officials. The market
determines the price of the currency.
Exchange Rate Regimes
What is a “clean” float? A “dirty” one?
- With a dirty float the government doesn’t
peg the currency, but tries from time to time
to influence the rate by buying or selling in
the currency markets.
Fixed Exchange Rates


How can the government keep a currency
at a certain value if international commerce
becomes unwilling to pay that price?
It can’t maintain the value for long. If the
demand for the currency falls, it’s price
would fall as well.
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 exchange
market and bid the price of the currency
back up by purchasing it.
Fixed Exchange Rates

The government must buy the amount
that will bring the quantity demanded
back to the original level.
$ Price of Franc
Supply of Francs
Demand for Francs
Quantity of exchange
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?
Fixed Exchange Rates

How does the government defend the fixed
value against any market pressures
pushing toward higher or lower exchange
rate value?
Fix to what?
In the past, all currencies were fixed to
gold.
 Today, a country can fix its value to
another country’s currency.

Fix to what?

A country can fix its currency to a
“basket” of other currencies.
-Same as diversifying a portfolio (Not
putting all your eggs in one basket)
-Special Drawing Right (SDR)…A basket of
four major world currencies.
Defending a Fixed Exchange Rate
1.
2.
To buy or sell foreign currencies (in order to
influence the prevailing exchange rate), a government
must have foreign exchange reserves.
It is not likely to have enough reserves to defend
against a massive and sustained attack on the
currency. What is an attack on a country’s currency?
(Answer: Massive “selling off” of a currency
expected to be devalued. One can borrow the
attacked currency and pay it back after devaluation.)
Defending a Fixed Exchange Rate in the
Exchange Markets: the Interest Rates


How can higher i rates keep the currency value
up?
(Answer: Foreigners will purchase the nation’s
currency, bidding its value upward, to make
short-term investments in the country.)
Defending a Fixed Exchange Rate
by changing the “fundamentals”
3.
Long-term adjustments of its
macroeconomic (monetary and/or fiscal)
policy.
Budget austerity avoids inflation and
takes downward pressure off currency.
Inflation Puts Downward Pressure
On the Exchange Rate


THE DEMAND SIDE:
Non-inflating countries are unwilling to pay
more and more to buy an inflating country’s
goods and services. Reduced demand for the
inflating currency will make it depreciate.
Inflation Puts Downward Pressure
On the Exchange Rate
SUPPLY SIDE:

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.
EXAMPLE: 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 be
purchased with Mexican prices going up.)
Defending The Peso Under Attack
1.
The Mexican government intervenes in
currency markets, purchasing pesos to
maintain their value and promises it will
never permit its value to fall.
Defending The Peso Under Attack
4.
The attack will be under way if people
don’t 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.
Defending The Peso Under Attack
4.
5.
The Mexican government soon runs out of
reserves and lets the peso price fall.
People purchase pesos back at the new,
lower rate for good gains.
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.
When to Change the Rate?


A pegged exchange rate sets a targeted value for
a country’s foreign exchange, and the
government can adjust the peg.
The government may use an adjustable peg.
or a crawling peg. The rate may be changed if
there is a substantial disequilibrium in the
country’s international position (e.g., demand for
the currency is too weak to maintain the desired
value).
Monetary Policy with Fixed Exchange Rates
Expanding the Money Supply Worsens the Balance of Payments
Capital flows out.
(in the short run)
To improve a poor
macroeconomic
situation, a
country increases
its money supply
so that banks are
more willing to
lend.
The overall
payments balance
“worsens.”
Interest rate
drops
Real spending,
production, and
income rise, but
The price level
increases.
The Current account
balance “worsens” as
exports fall and imports
increase.
Monetary Policy with Floating Exchange Rates
Effects of Expanding the Money Supply
Capital flows out.
(In the short run)
With an
increase in the
money supply,
banks are
more willing
to lend.
Currency
depreciation and
automatic
adjustment begins!
Interest
rate
drops
Real spending,
production, and
income rise.
Current account
balance “worsens.”
The Price level
increases.
(Beyond the short run)
The
Current
account
balance
improves
Real
product
and
income
rise more
In Conclusion
 Fixed
exchange rates are
government controlled.
 Floating exchange rates are market
driven.
In Conclusion

But as financial markets have
developed to accommodate for flexible
exchange rates, more and more
countries have come to appreciate the
value of market determination.