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| Fixed
and Floating Exchange Rate Systems |
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Introduction 3
1. History of exchange rate systems 4
1.1. Commodity money 4
1.2. Paper money 4
1.3. The gold standard 4
1.4. The Bretton-Woods system 6
1.5. Deficiencies of Bretton-Woods system 7
1.6. Further development of exchange rate systems 8
1.7. Modern variants of exchange rate systems 12
2. Pros and Cons of Each System 14
2.1. Advantages of fixed exchange rate system 14
2.2. Disadvantages of fixed exchange rate system 15
2.3. Advantages of floating interest rate system 16
2.4. Disadvantages of floating rate exchange system 17
4. Examples of exchange rate management 20
Conclusion 25
Literature 27
Introduction
An exchange rate is the rate at which one currency is exchanged
on another one. This rate differs from country to country
and depends on many economical variables, the main of which
are the general balance and disbalance 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.
The history of world exchange rate systems shows us that the
world community (in its majority) has in fact shifted from
the system of fixed exchange rates to floating exchange rate
system. Currently there exist different combinations of floating
and fixed exchange rate systems, together with specific economical
instruments, created for exchange rate regulating.
This essay is aimed to describing the existing exchange rate
systems, their impact on local and international economy and
analysis of pros and cons of each system. This essay also
contains an attempt to show the examples of exchange rate
management in different countries, and analyze their consequences;
the return effects of exchange rate management on the condition
of major economical variables have also been regarded and
a conclusion basing on all the above-listed material has been
made.
1. History of exchange rate systems
1.1. Commodity money
Since the development of production and a number of divisions
of labor there existed such a phenomenon as commodity money.
There was no other monetary system until 17th century when
there appeared coins having an intrinsic value, not linked
with commodity. Usually the value of the coin was associated
with the content of gold in the coin. The exchange rate between
different coins and different currencies depended on the content
of gold in the coin as well, and equaled to the relative content
of gold in the coins.
1.2. Paper money
In 17th century banks started issuing own banknotes which
had the same purchasing power as coins and were backed by
precious metals in the banks. People could convert these banknotes
into precious metals if they wished so. It is important to
note that this backing was not 100%.
1.3. The gold standard
With the development of this system (the so-called fractional
reserve banking) and with the development of international
relations the idea of the gold standard appeared. In 1870
major countries had an agreement to base their exchange rates
on the gold standard: the amount of gold which was backed
for the banknote by the bank. Therefore the exchange rates
between different countries equaled to the ratio of gold content
linked with the currencies. This system existed until 1913,
and, as we can see, represented the fixed exchange rate idea
(since the gold content of each currency was fixed).
None of the countries offered 100% backing for their currency,
and therefore the demand and purchasing power of a particular
currency depended on the credibility of the currency; the
countries with weaker or slower economical development had
less credible currencies. The problems started to appear after
World War I, when most of the countries were trying to improve
their economical condition after the war and were undertaking
speculative attacks, to increase the purchasing power of their
currency and to decrease the purchasing power of other countries.
Naturally, 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 fixed exchange rate system.
With the development of financial and banking system the backing
of currencies has shifted from gold standard to backing by
government debt instruments, such as treasury bills etc. Since
the currencies progressively less depended on the gold content,
the main variable that defined the purchasing power of a currency
was the credibility of it. Economical fluctuations and crisis
specified the instability in currency exchange rates. Until
World War II the world community has undertaken attempts to
return to the gold standard, but they were not very successful
because of the changed economical conditions [7, p.12].
1.4. The Bretton-Woods system
After World War II the major countries adopted the Bretton-Woods
system, which continued the policy of fixed exchange rates,
but offered a shift from the inefficient gold standard to
the so-called gold exchange standard. The exchange rates were
fixed compared not to gold, but to the US dollar; the US dollar,
in its turn, was linked by a specific exchange rate with gold.
The change of exchange rates (either devaluation or evaluation)
was allowed only in extreme cases. This system strengthened
the position of the US as a dominating economy, and affected
the exchange rates of countries with weaker economies.
As an attempt to solve this disbalance, the International
Monetary Fund (IMF) has been created. The countries with weaker
economies were given loans on specific conditions to improve
their economical state. Nevertheless, the huge gap between
the stability and level of exchange rates of dominating countries
and the exchange rates of other countries proved that the
existing exchange rate system needed to be improved.
The main controversy between exchange rates and domestic policies
is that, on one hand, fixed exchange rates offer relative
stability and better conditions for local and international
trade conditions; the enterprisers could easily predict the
rates and plan their work according to this. On the other
hand, to eliminate instability and stimulate economical growth,
it is required that currencies could be exchanged without
any restrictions [7, p.50]. And the last condition that is
necessary for sound economical development is that governments
have to conduct monetary and fiscal policies without any restrictions
in order to be able to cope with appearing crises, reduce
such factors and unemployment and inflation etc.
1.5. Deficiencies of Bretton-Woods system
Unfortunately these three conditions cannot be reached within
the terms of one economical system; one of them is always
not compatible with the other two conditions. For example,
if the state chooses free and unlimited currency conversion
and fixed exchange rate policy, it is then unable to provide
domestic interventions in order to control appearing economical
disbalances and becomes very vulnerable to outer economical
interventions and speculative attacks. If the state provides
strong domestic policy and controls the appearing economical
troubles such as inflation and unemployment, and at the same
time offers free and unrestricted conversion of currencies,
it will be unable to keep the exchange rate on a desired level
because the changing demand for the currency and changing
economical conditions will require to devalue or revalue the
national currency. And finally, if the state chooses to have
strong domestic policy and fixed exchange rates in order to
reach economical stability, it will have to limit the amount
of converted currencies to preserve the exchange rate in the
proper scope.
Depending on these three main factors, three main exchange
rate systems have appeared: fixed exchange rate system, floating
(or flexible) exchange rate system, and managed exchange rate
system which combined both above-listed systems.
1.6. Further development of exchange rate systems
Let us now return to historical development of exchange rate
systems. The Bretton-Woods system existed until 1973. In 1971
there was an attack on the US dollar which made it significantly
overvalued against other currencies; but the US government
did not try to protect the dollar value, and therefore the
floating of dollar exchange rate started. There was an attempt
to return back to fixed rate system in 1973, but it didn’t
have any significant effect and as other currencies were strongly
linked to dollar value, the world exchange rate system gradually
shifted from fixed exchange rate to floating exchange rate.
The attitude to this shift is different in different parts
of the world, and it specified the emergence of three distinct
types of exchange rate systems (they were listed above) and
different combinations of these types.
It is historically conditioned that the US supports the idea
of self-adjusting market; therefore the US government mostly
supports floating exchange rate system. The European community
has mostly provided the policies of regulating their economy
and intervening into market mechanism; therefore countries
of these region have hosen the direction towards a fixed exchange
rate system and finally, towards a common currency in 1999.
The European Monetary System (EMS) has been created in 1979;
it included 15 countries of Europe and offered the fixation
of exchange rates of one currency compared to another one;
the rates for the pairs of currencies differed which allowed
more flexibility than simply fixing exchange rates. This system
also allowed the change of the exchange rate in certain situations;
for weaker countries the fluctuation barrier has been made
wider than for dominating countries [3, p. 42]. As a development
of this system, euro has been created; in 1999 all currencies
have been fixed against euro and finally in 2002 all currencies
were replaced by euro.
The countries of Asian region in their majority opted for
the stability of their exchange rate and introduced the policies
that linked the national currency to the dollar value and
let it fluctuate only in small scope around the dollar value.
The dynamics of currencies during the 20th century can be
illustrated by the exchange rate between dollar and pound
in the period from 1957 to 2001(fig.1).
1.7. Modern variants of exchange rate systems
Today there exist three major currencies: dollar, euro and
yen; other currencies are in some way dependent from these
ones.
Currently we can witness the development of three major exchange
rate systems and several their modifications. The countries
that use managing exchange rate system have worked out several
policies for maintaining economic stability. One of the long-living
policies is the usage of currency boards. The idea of a currency
board means full backing of international currency reserves.
Since the countries using fixed exchange rate systems need
to have reserves of international currency, one of their main
problems is to cover the excess demand for foreign currency
in case of instability; and the main reason that causes economical
disbalance in such countries, is the inability to cover excess
demand and therefore the inability to keep the fixed exchange
rate on the desired level. This problem can be avoided by
currency board: i.e. the bank only issues as much national
money, as it can cover by the reserves of international currency.
Such systems have proved their viability, but, like all fixed
exchange rate systems, they are still vulnerable to the speculative
attacks. However, the examples of Argentinean and Hong Kong
currency boards show us that these systems can be effective,
at least in the short run.
The other economical instruments that are used for exchange
rate managements, are pegging the currency (either to one
currency, or to the basket of currencies), accepting a managed
float for a specific currency within the region where different
currencies are in use, and letting the currency to float freely
against all other currencies.
2. Pros and Cons of Each System
Since exchange rates and economies of all countries have experienced
significant instability in 20th century, there have appeared
a lot of arguments concerning the choice of exchange rate
system. Since the fixed exchange rate system has been widely
used before, there have been a lot of its supporters. The
main their argument has been that floating exchange rates
mean instability. However, there appeared a number of researchers
offering arguments in favor of floating exchange rate system.
2.1. Advantages of fixed exchange rate system
First of all, fixed exchange rates offer much greater stability
for the enterprisers and stimulate international trade; since
the exchange rates stay on the same level, the importers and
exporters can plan their policy without begin afraid of depreciation
or appreciation of the currency. Moreover, fixed exchange
rates make the producers more disciplined, i.e. they 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. This advantage of fixed exchange
rates allows the government to decrease inflation level and
stimulate international trade and economical growth in the
long period [10, p. 37].
Secondly, it is believed that fixed exchange rates stimulate
the reduction of speculative activity worldwide; but this
statement is true under the condition that the adopted exchange
rates are profitable for the foreign dealers as well as for
domestic ones (closer examination of this condition shows
us that monetary and fiscal policies attempting to protect
domestic producers – which are often required to preserve
economical stability – violate this condition and therefore
create the ground for speculative intervention).
2.2. Disadvantages of fixed exchange rate system
The main disadvantage of it is the high vulnerability of the
economical system to speculative attacks. Any economy experiences
excess supply and demand in either national or foreign currency:
and if the national banks are unable to cover the gap between
the existing resources and demand, the fixed rate needs to
be changed; this situation reduces the positive effects of
the fixed rate exchange system and decreases the credibility
of the currency.
One more disadvantage of this system is that if the government
artificially supports the exchange rate, which is not adjusted
to changed economical condition, the development of the country’s
economy is not as efficient as it could be if the rate was
adjusted to the situation. Moreover, interest rates, which
directly depend on the exchange rate, can stop possible economical
growth in case of their disparity to market needs.
In the conditions when the national currency is tied to some
international currency, there exists very significant dependence
of the condition of these countries’ economical stability.
In this case the government is actually forced to solve the
economical problems of the countries, with currency of which
it is linked. This situation creates the possibility for dominating
countries to improve the state of their economy at the expense
of related countries with weaker economies; and at the same
time destabilizes the market situation in these related countries.
I think that taking into consideration the growing economical
and political integration, the strengthening of the economical
connection between countries, the fast development of world
trade and economical specialization, the advantages of fixed
interest rates do not cover the losses caused by the restrictions
imposed by this system.
2.3. Advantages of floating interest rate system
The main advantage of this system is its flexibility and the
possibility for the country’s economy to be quickly
adjusted to changing market conditions. 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 either more competitive
(in case of appreciation on the currency market) or makes
foreign goods more competitive (in case of the currency’s
depreciation).
The second advantage of floating exchange rate system is that
it automatically determines interest rates within the country
and therefore allows controlling the economical balance more
effectively.
2.4. Disadvantages of floating rate exchange system
It is believed that this exchange rate system leads to instability
on the market and does not stimulate the development of trade
and production; floating exchange rates destabilize economical
situation and lead to economical crises. The instability of
exchange rates after the end of Bretton-woods system and the
whole depression in world economy at that time illustrated
this point of view; however, with the flow of time the economists
started regarding this system from a different point of view:
the work of Milton Friedman in 1953 opposed the common belief
that instability was caused by the float of exchange rates.
Friedman stated that instability was caused by wrong economical
policy of the governments and other factors, not depending
on the exchange rates mechanism. Indeed, the effects of flexible
exchange rates on the stability of prices and production have
appeared to be much smaller than they were expected to be;
for example, in Germany in 1980s the purchasing power of DM
shifted from 20% above the purchasing power of USD to 25%
below this level, and then returned to 25% above USD purchasing
power. According to the predictions, this shift has to cause
significant disbalance in German economy; but contrary to
these assumptions, the changes were very modest. It has appeared
that most producers chose to keep up with the strategy of
“pricing to market”. This means that the prices
of the goods remained stable in the currency of importing
country, and therefore they were not heavily destabilized
by the shift in exchange rates.
The instability of exchange rates is the main argument of
floating exchange rates opponents. However, besides Friedman’s
explanations, there have been other attempts to explain this
great instability. For example, Dornbush in 1976 suggested
that there existed a phenomenon of “over-shooting”.
This means that to be successful in the long run the economy
needs to depreciate its currency, in order to reduce inflation
and stimulate economical growth. However, in the short period
depreciation will cause the decrease of interest rates and
the fall of activity; in order to stimulate the activity of
firms, the currency needs to be expected to rise in future.
The only variant that can provide depreciation in the long
run together with the expected rise of the purchasing power
of the currency is the fall of the currency lower than it’s
needed in the long run; for example, if the money supply of
the country rises by 5%, its currency needs to be depreciated
by 5% in the long run – but to stimulate economical
activity, the currency needs to be depreciated by 15% with
expected rise by approximately 10% (the so-called mechanism
of “over-shooting”).
Another advantage of floating rate system is that it allows
the government to introduce separate monetary and fiscal policies,
which is rather difficult under the conditions of a fixed
exchange rate system. In general, the arguments between the
supporters and opponents of floating exchange rate system
lie in the relation between the price paid for the instability
of exchange rates and the possibility to introduce independent
monetary and fiscal policy, and therefore to adjust quickly
to changing economical conditions.
4. Examples of exchange rate management
Exchange Rate Arrangements as of December 31, 1997
Pegged
Single currency Currency composite
U.S. dollar
Angola
Antigua and Barbuda
Argentina
Bahamas, The
Barbados
Belize
Djibouti
Dominica
Grenada
Iraq
Lithuania
Marshall Islands
Micronesia, Federated States of
Nigeria
Oman
Panama
St. Kitts and Nevis
St. Lucia
St. Vincent and the Grenadines
Syrian Arab Republic French franc
Benin
Burkina Faso
Cameroon
Central African Rep.
Chad
Comoros
Congo, Rep. of
Cote d’Ivoire
Equatorial Guinea
Gabon
Guinea-Bissau
Mali
Niger
Senegal
Togo Other
Bhutan
(Indian rupee)
Bosnia and Herzegovina
(deutsche mark)
Brunei Darussalam
(Singapore dollar)
Estonia
(deutsche mark)
Kiribati
(Australian dollar)
Lesotho
(South African rand)
Namibia
(South African rand)
San Marino
(Italian lira)
Swaziland
(South African rand) SDR
Latvia
Libyan Arab
Jamahiriya
Myanmar Other
Bangladesh
Botswana
Burundi
Cape Verde
Cyprus
Czech Republic
Fiji
Iceland
Jordan
Kuwait
Malta
Morocco
Nepal
Seychelles
Slovak Republic
Solomon Islands
Thailand
Tonga
Vanuatu
Western Samoa
Flexibility Limited vis-a-vis a Single Currency or Group
of Currencies More Flexible
Single currency Cooperative arrangements Other managed floating
Independently floating
Bahrain
Qatar
Saudi Arabia
United Arab Emirates Austria
Belgium
Denmark
Finland
France
Germany
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain Algeria
Belarus
Brazil
Cambodia
Chile
China, People’s Rep. of
Colombia
Costa Rica
Croatia
Dominican Republic
Ecuador
Egypt
El Salvador
Georgia
Greece
Honduras
Hungary
Indonesia
Iran, Islamic Rep. of
Israel
Kazakhstan
Kyrgyz Republic
Lao P.D.R.
Macedonia, former Yugoslav Rep.of
Malaysia Maldives
Mauritius
Nicaragua
Norway
Pakistan
Poland
Russian Federation
Singapore
Slovenia
Sri Lanka
Sudan
Suriname
Tunisia
Turkey
Turkmenistan
Ukraine
Uruguay
Uzbekistan
Venezuela
Vietnam Afghanistan, Islamic State of
Albania
Armenia
Australia
Azerbaijan
Bolivia
Bulgaria
Canada
Eritrea
Ethiopia
Gambia, The
Ghana
Guatemala
Guinea
Guyana
Haiti
India
Jamaica
Japan
Kenya Republic
Korea
Lebanon
Liberia
Madagascar
Malawi Mauritania
Mexico
Moldova
Mongolia
Mozambique
New Zealand
Papua New Guinea
Paraguay
Peru
Philippines
Romania
Rwanda
Sao Tome and Principe
Sierra Leone
Somalia
South Africa
Sweden
Switzerland
Tajikistan, Rep. of
Tanzania
Trinidad and Tobago
Uganda
United Kingdom
United States
Yemen, Rep. of
Zaire
Zambia
Zimbabwe
The recent Asian crisis and a number of currency falls that
took place in Argentina, Chile etc. raised the question about
the correlation between exchange rate system, the purchasing
power of the currency and the state of national economy. There
exists an opinion that the undervaluation of euro and the
related overvaluation of US dollar, which led to the consolidation
of European Union and increased the level of its export, has
also negatively affected the developing market economies in
Asia and Latin America, and actually was the reason of the
financial crisis in these regions. However, after the Bank
of European Union decreased the level of euro undervaluation,
the market situation has improved [10, p. 83].
Though the process of European integration shows the stable
and confident economical growth in his region, a lot of researchers
believe that in the long run this economical union will be
forced to change into some form of political union, where
the countries will represent themselves and introduce separate
policies. The possible dangers of the common currency mechanism
depend on the state of economy of each member of the union;
if one country experiences problems, it leads to the instability
in the whole union. The possibility of this dangerous situation
can be well illustrated by the example of the UK, which had
to leave the ERM system in order to be able to introduce domestic
policy and adjust interest rates (which helped to get the
UK economy out of the long recession).
The countries that use currency boards, also are exposed to
the dangers of instability more than countries with flexible
exchange rates: an example of this is the financial crisis
in Argentina. Though currency boards have proved their right
for existence (for example Hong Kong has been practicing currency
boards for almost two decades), the use of currency boards
imposes rather high restrictions on the country, the country
practicing it needs to have rather strong and sound economy.
Argentina, Bulgaria, Lithuania, Estonia – all these
countries managed to stop the cycle of high inflation level
by using currency boards; but this method can work only as
an urgent measure, but is rather inefficient and even dangerous
in the long run.
In general, every country and every region in the world have
different historical background and therefore have to choose
own economical policies. But at the same time, if the world
community is becoming more and more integrated, it is natural
that the mechanisms of regulating national economy have to
be coordinated with the general trend of economical development.
As the managing director of the International Monetary Fund
Horst Kohler indicated during the Asia-Europe Meeting of Finance
Ministers in 2001: “The process of integration in Europe
has not yet ended, and its final outcome is still to be determined…
I am not here to suggest that the European experience is a
model that Asia can and should copy. Regional developments
in Asia should be driven by is own political dynamics and
unique historical background. But trading patterns and geography
do make it reasonable to think of the creation of an internal
market in Asia as possible, future stage in regional cooperation.
And why should this not be a basis for greater monetary integration,
if that is what people of Asia desire?”
Conclusion
In the current world, where globalization, informatization
and technical progress play the leading role, old economic
factors and variables are being replaced by new ones. The
process of globalization, together with the development of
communication means and increase of international trade, in
the conditions of international labor specialization etc.
defines the importance of economical flexibility. Therefore
the advantages of the existing fixed exchange rate systems
and the measures of pegging the currency to a stronger one
are gradually losing their advantage. The choice for stability
at the extent of flexibility and independence of monetary
and fiscal policy is, in my opinion, no more justified in
the new conditions. The importance of shift from the fixed
exchange rate system to flexible exchange rates can hardly
be overestimated. However, in case of poor economical policy
and non-balanced government management of the economy can
reduce all the advantages of flexibility. Moreover, as the
economical ties between countries strengthen, the responsibility
on the government concerning monetary and fiscal policy increases,
because now the economical crisis in one country easily develops
into world economical depression.
In general, most international economists today state that
the benefits of integrating into world financial system and
liberalization of financial markets exceed the risks of instability,
and the future is promising greater perspectives for the countries
whose financial system is based on the floating exchange rate
system. The level of financial liberty can be different for
different regions of the world, and the policies that can
lead them to economical growth can also be different, but
the general belief is that the flexible exchange rate system
offers better opportunities for successful economical development
than fixed exchange rate system.
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3. Friedman, Milton. "The Case for Flexible Exchange
Rates." In Friedman. Essays in Positive Economics. 1953.
4. Hansen, Lars, and Robert Hodrick. "Forward Exchange
Rates as Optimal Predictors of Future Spot Rates: An Appraisal."
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