Exchange Rate Systems

Floating Exchange Rate Systems

Free Floating

Changes in the demand and supply of a currency will lead it to either appreciate or depreciate.  Short run factors that will affect the demand for a currency include:

• To purchase goods and services from another country.
• To invest in another country.
• Speculating on the currency.
• To take advantages of rises in interest rates.

In the long run, it is the macro economic performance of the economy that will drive the value of the currency.  The price of a currency is determined using the normal interactions of demand and supply.

There is no official target for the exchange rate set by the government or central bank.  This allows interest rates to be set to pursue other economic targets rather than attempting to achieve a certain exchange rate.

What objective are interest rates in the UK used to pursue?

A free floating exchange rate can be used as an automatic stabiliser to reduce a deficit on the current account on the balance of payments.

The pound has free floated on the foreign exchange markets since the UK suspended membership of the ERM in September 1992.

Managed Floating

Again, the value of the pound is determined by demand and supply with no pre-determined target.  In cases of extreme appreciation or depreciation, the central bank will normally intervene to stabilise the currency.  Governments frequently engage in managed floating; this was the policy pursued from 1973-90.

SEMI-FIXED

The exchange rate is given a specific target.  The currency is allowed to move between permitted bands of fluctuation.  The Bank of England and other central banks may have to intervene to maintain the value of the currency within the set targets.  This was followed between October 1990 and September 1992 when the UK was part of the ERM.

Fixed Exchange Rate Systems

This requires the exchange rate to be fixed against one or more other currencies and no fluctuations are allowed.  The UK was part of the Bretton-Woods System between 1944 and 1972 where currencies were tied to the US dollar.  The countries joining the euro tied the currencies to each other in 1999 until the euro was introduced in January 2002.

Fixed rates gives greater certainty for firms who export and import goods and services as they are able to plan future costs and revenues with greater certainty.

If firms know that a currency won’t be devalued they are more likely to be more disciplined with their approach to minimising costs.

Why will a firm have more incentive to keep costs under control if it knows that the currency won’t be devalued?