Fixed and floating exchange rate systems

Overview

Floating exchange rate system, fixed exchange rate system and managed float.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is a floating exchange rate system?

   Model answer

   Under a floating system the exchange rate is determined entirely by the demand for and supply of the currency in the market, with no commitment by the authorities to any particular level and no obligation to intervene. The rate moves continuously to whatever level equates demand and supply, and the central bank is free to set interest rates for domestic purposes.

2. 2

   What is a fixed exchange rate system?

   Model answer

   Under a fixed system the authorities announce a value for the currency against another currency, a basket of currencies or a commodity, and commit to maintaining it. They do so by buying their own currency with reserves when it would otherwise fall, selling it when it would otherwise rise, and adjusting interest rates to make holding the currency more or less attractive. The rate is therefore a policy decision rather than a market outcome.

3. 3

   What is a managed float?

   Model answer

   A managed float is an arrangement in which the exchange rate is broadly determined by the market but the authorities intervene from time to time to smooth movements they regard as excessive or to resist a trend they judge harmful, without committing to any announced level. It occupies the middle ground: the country keeps most of the flexibility of a float while retaining the option to act, but it also gives up some of the credibility of a clear commitment because the market cannot be sure what the authorities will do.

4. 4

   Explain how a central bank maintains a fixed exchange rate when there is downward pressure on the currency.

   Model answer

   Downward pressure means the quantity of the currency being supplied at the fixed rate exceeds the quantity demanded. The central bank absorbs the excess by buying its own currency, paying for it with foreign currency from its reserves, which adds to demand and holds the rate at the peg. If the pressure persists, reserves fall, so the bank must also raise interest rates to make holding the currency more attractive, or ultimately reduce domestic demand to cut imports. Each of these is costly, which is why sustained pressure eventually forces either a devaluation or the abandonment of the peg.

5. 5

   Explain how a central bank prevents a fixed exchange rate from rising.

   Model answer

   Upward pressure means demand for the currency at the fixed rate exceeds supply, so the central bank supplies the excess by selling its own currency and buying foreign assets, which accumulate as reserves. It can create its own currency without limit, so this side of the operation can continue indefinitely. The cost is that the newly created currency expands the domestic money supply and risks inflation unless it is sterilised by selling domestic bonds, and that the country accumulates a large stock of low-yielding foreign assets.

6. 6

   What does a country gain from fixing its exchange rate?

   Model answer

   It removes exchange rate uncertainty for firms trading with the anchor country, which lowers the cost of hedging and encourages trade and long-term investment. It imposes discipline on domestic policy, because inflation above that of the anchor country cannot be accommodated by a falling currency and must instead be corrected, which can give a country with a poor inflation record borrowed credibility. It removes the possibility of destabilising speculation as long as the peg is believed, and it makes prices in international trade predictable, which is particularly valuable for small open economies heavily dependent on a single trading partner.

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