Fixed and Floating Exchange Rate Systems

Fixed and Floating Exchange Rate Systems

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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