In a fixed exchange rate system, the government (or the central bank
acting on the government's behalf) intervenes in the currency market so that
the exchange rate stays close to an exchange rate target. When Britain joined
the European Exchange Rate Mechanism in October 1990, we fixed sterling
against other European currencies. The pound, for example, was permitted to
vary against the German Mark by only 6% either side of a central target of
DM2.95. Britain left the ERM in September 1992 when the pound came under
sustained selling pressure, and the authorities could no longer justify very
high interest rates to maintain the pound's value when the domestic economy
was already suffering from a deep recession.
Since autumn 1992, Britain has adopted a floating exchange rate system.
The Bank of England does not actively intervene in the currency markets to
achieve a desired exchange rate level.
In contrast, the twelve members of the Single Currency agreed to fully
fix their currencies against each other in January 1999. In January 2002,
twelve exchange rates became one when the Euro entered common circulation
throughout the Euro Zone.
EXCHANGE RATE SYSTEMS FOR THE UK SINCE 1944
1944-72: Fixed Exchange Rates
Occasional devaluations against dollar (1948 and 1967)
1972-87: Managed Floating
1987-88: Shadowing the DM (Under Chancellor Nigel Lawson)
1988-90: Managed Floating (prelude to ERM entry)
1990-92: Semi-Fixed Exchange Rates
1992-01: Floating Exchange Rate
Bank of England has not intervened in the currency markets for the last
nine years meaning that Sterling has been market determined.
Types Of Exchange Rate System
With floating exchange rates, changes in market demand and market supply
of a currency cause a change in its value.
Trade flows and capital flows are the main factors affecting the
exchange rate. In the long run
it is the macro economic performance of the economy (including trends in
competitiveness) that drives the value of the currency (see later notes).
No pre-determined official target for the exchange rate is set by the
Government. The government and/or monetary authorities can set interest rates
for domestic economic purposes rather than to achieve a given exchange rate
target. It is rare for pure free
floating exchange rates to exist - most governments at one time or another
seek to "manage" the value of their currency through changes in
interest rates and other controls
UK sterling has floated on the foreign exchange markets since the UK
suspended membership of the ERM in September 1992
MANAGED FLOATING EXCHANGE RATES
Value of the pound determined by market demand and supply of the currency
with no pre-determined target for the exchange rate is set by the Government.
Governments normally engage in managed floating if not part of a fixed
exchange rate system. Policy
pursued from 1973-90 and since the ERM suspension from 1993-1998
SEMI-FIXED EXCHANGE RATES
Exchange rate is given a specific target. Currency can move between permitted bands of fluctuation.
Exchange rate is dominant target of economic policy-making (interest
rates are set to meet the target). Bank
of England may have to intervene to maintain the value of the currency within
the set targets. Re-valuations
possible but seen as last resort. October
1990 - September 1992 during period of ERM membership
FULLY-FIXED EXCHANGE RATES
Commitment to a single fixed exchange rate. No permitted fluctuations from the central rate.
Achieves exchange rate stability but perhaps at the expense of
domestic economic stability. Bretton-Woods
System 1944-1972 where currencies were tied to the US dollar.
Gold Standard in the inter-war years - currencies linked with gold.
Countries joining EMU in 1999 . fixed their exchange rates until the
Euro was introduced in January 2002.
Advantages Of Floating Exchange Rates
Fluctuations in the exchange rate can provide an automatic
adjustment for countries with a large balance of payments deficit.
If an economy has a large deficit, there is a net outflow of currency
from the country. This puts downward pressure on the exchange rate and if a
depreciation occurs, the relative price of exports in overseas markets falls
(making exports more competitive) whilst the relative price of imports in the
home markets goes up (making imports appear more expensive).
This should help reduce the overall deficit in the balance of trade
provided that the price elasticity of demand for exports and the price
elasticity of demand for imports is sufficiently high.
A second key advantage of floating exchange rates is that it gives the
government / monetary authorities flexibility in determining interest
rates. This is because interest rates do not have to be set to keep
the value of the exchange rate within pre-determined bands.
For example when the UK came out of the Exchange Rate Mechanism in
September 1992, this allowed a sharp cut in interest rates which helped to
drag the economy out of a prolonged recession.
Advantages Of Fixed Exchange Rates
Fixed rates provide greater certainty for exporters and
importers and under normally circumstances there is less speculative
activity - although this depends on whether the dealers in the
foreign exchange markets regard a given fixed exchange rate as appropriate
and credible. Sterling came under intensive speculative attack
in the autumn of 1992 because the markets perceived it to be overvalued and
ripe for a devaluation.
Fixed exchange rates can exert a strong discipline on domestic firms and
employees to keep their costs under control in order to remain competitive in
international markets. This helps the government maintain low inflation -
which in the long run should bring interest rates down and stimulate
increased trade and investment.
Countries With Different Exchange Rate Regimes
Countries with fixed exchange rates often impose tight controls on
capital flows to and from their economy. This helps the government or the
central bank to limit inflows and outflows of currency that might destabilise
the fixed exchange rate target,
The Chinese Renminbi is essentially fixed at 8.28 renminbi to the US
dollar. Currency transactions involving trade in goods and services are
allowed full currency convertibility. But capital account transactions are
tightly controlled by the State Administration of Foreign Exchange.
The Hungarians have a semi-fixed exchange rate against the Euro with the
Forint allowed to move 2.5% above and below a central rate against the Euro.
The Hungarian central bank must give permission for overseas portfolio
investments on a case by case basis.
The Russian rouble is in a managed floating system but
there is a 1% tax on purchases of hard currency. In contrast, the Argentinean
peso was pegged to the US dollar at parity ($1 = 1 peso) and international
trade transactions (involving current and capital flows) were not subject to
stringent government or central bank control (recent devaluation means parity
no longer occurs).
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