Fixed vs. Floating Rates

Introduction

Key Concepts

Exchange Rate Defined

The exchange rate represents the price of one country's currency in terms of another's. It dictates how much of one currency can be exchanged for another and is fundamental in determining the cost of imports and the revenue from exports.

Fixed Exchange Rates

A fixed exchange rate system, also known as a pegged exchange rate, is one where a country's currency value is tied or pegged to another major currency or a basket of currencies. The primary objective is to maintain currency stability and reduce exchange rate volatility.

Advantages of Fixed Exchange Rates:

• Stability: Reduces uncertainty in international transactions, fostering trade and investment.
• Inflation Control: By pegging to a stable currency, countries can import low inflation rates.
• Discipline: Limits the government's ability to engage in excessive monetary expansion.

Disadvantages of Fixed Exchange Rates:

• Loss of Monetary Policy Independence: The central bank must prioritize maintaining the peg over domestic economic objectives.
• Vulnerability to Speculative Attacks: If the market perceives the peg as unsustainable, it can lead to speculative pressures.
• Requires Large Foreign Exchange Reserves: To defend the peg, significant reserves are necessary.

Floating Exchange Rates

In a floating exchange rate system, the value of the currency is determined by market forces, primarily supply and demand relative to other currencies. Governments and central banks allow the currency to fluctuate freely without direct intervention.

Advantages of Floating Exchange Rates:

• Monetary Policy Independence: Allows central banks to focus on domestic economic conditions without worrying about maintaining a currency peg.
• Automatic Adjustment: Exchange rates can adjust to correct trade imbalances, promoting economic equilibrium.
• Reduced Vulnerability to Speculative Attacks: Without a fixed peg, there's less incentive for speculative attacks against the currency.

Disadvantages of Floating Exchange Rates:

• Exchange Rate Volatility: Can lead to unpredictability in international trade and investment.
• Potential for Inflation: Depreciation can increase the cost of imports, contributing to inflation.
• Uncertainty: Businesses face challenges in pricing and planning due to fluctuating exchange rates.

Managed Float System

A managed float, or dirty float, is a hybrid exchange rate system where the currency primarily floats in the open market but the central bank intervenes occasionally to stabilize or steer the currency towards a desired value.

Advantages of Managed Float:

• Flexibility: Combines the benefits of floating rates with some level of control to reduce excessive volatility.
• Economic Stability: Central banks can intervene to prevent extreme fluctuations that may harm the economy.

Disadvantages of Managed Float:

• Uncertainty about Intervention: Market participants may be unsure when and how the central bank will intervene.
• Potential for Inconsistent Policy: Frequent interventions can lead to misaligned monetary policies.

Factors Influencing Exchange Rate Systems

• Economic Stability: Countries with stable economies may prefer fixed rates to harness predictability.
• Trade Balance: Nations with significant trade surpluses or deficits might choose an exchange rate system that best addresses their trade dynamics.
• Inflation Rates: Lower inflation rates support fixed exchange systems by ensuring price stability.
• Speculative Activities: Susceptibility to speculative attacks can influence the choice between fixed and floating systems.

Theoretical Explanations

Purchasing Power Parity (PPP)

PPP theory states that in the long run, exchange rates should adjust to equalize the price of identical goods and services in different economies. If a country's inflation rate is higher than another's, its currency should depreciate to restore parity.

Interest Rate Parity (IRP)

IRP suggests that the difference in interest rates between two countries is equal to the expected change in exchange rates. This concept links exchange rates with financial markets and explains how interest rate differentials can influence currency values.

Real-World Examples

Fixed Exchange Rate Example: Hong Kong Dollar

Hong Kong maintains a fixed exchange rate by pegging its dollar to the US dollar within a narrow band. The Hong Kong Monetary Authority intervenes in the forex market to keep the exchange rate stable, ensuring economic stability and attracting foreign investment.

Floating Exchange Rate Example: United States Dollar

The US dollar operates under a floating exchange rate system where its value fluctuates based on market forces. The Federal Reserve focuses on domestic economic indicators like inflation and employment, allowing the exchange rate to adjust naturally.

Mathematical Representation

The exchange rate ($E$) can be influenced by factors such as interest rates ($i$) and inflation rates ($\pi$). The basic interest rate parity formula is: $$ i_d - i_f = \frac{E^e - E}{E} $$ where $i_d$ is the domestic interest rate, $i_f$ is the foreign interest rate, and $E^e$ is the expected future exchange rate.

Purchasing Power Parity can be expressed as: $$ E = \frac{P}{P_f} $$ where $P$ is the domestic price level and $P_f$ is the foreign price level.

Policy Implications

Governments must carefully choose their exchange rate systems based on economic goals. Fixed rates can promote stability and reduce uncertainty, benefiting trade and investment. However, they require substantial reserves and limit monetary policy flexibility. Floating rates offer more policy independence and automatic adjustment mechanisms but can lead to greater volatility. Managed floats attempt to balance these aspects by allowing flexibility while providing interventions to mitigate extreme fluctuations.

Impact on International Trade

Exchange rate systems directly affect import and export dynamics. A fixed rate can make a country's exports more predictable in price, encouraging trade partnerships. Conversely, a floating rate allows for automatic adjustments to trade imbalances; if a country has a trade deficit, its currency may depreciate, making exports cheaper and imports more expensive, thus correcting the deficit over time.

Volatility and Economic Stability

Exchange rate volatility can create uncertainty for businesses engaged in international trade. Fixed systems aim to minimize this volatility, fostering a stable trading environment. However, in the absence of fundamental economic alignment, fixed rates can lead to imbalances and crises. Floating rates, while volatile, may better reflect economic realities and provide resilience against external shocks.

Comparison Table

Summary and Key Takeaways