Exchange Rate Systems: Fixed Floating and Managed Rates
Exchange Rate Systems: Fixed, Floating, and Managed Rates.
Published on: wapdat25.blogspot.com
One of the most significant prices in an economy is the price of one currency in terms of another, also known as the exchange rate. It impacts imports costs, export competitiveness, inflation and savings value. The solution of this price is called the exchange rate system of a nation and the selection is of profound significance for economic stability and growth.
On a general level, exchange rate systems could be divided into three types: the fixed, the floating, and the mixed (managed) type.
An exchange-rate system in which the value of the currency remains constant.
In a fixed exchange rate regime, the central bank of a country fixes the rate of exchange of the currency and guarantees to keep it stable. This is frequently accomplished by fixing the currency to another larger currency, such as the U.S. dollar, a blend of currencies, or even a commodity such as gold .
How it works
For the central bank to keep the rate constant it has to intervene in the foreign exchange market. If the currency is threatened by depreciation, the bank will sell its foreign currency holdings (such as U.S. dollars) to acquire more of its own currency, thereby decreasing the supply and strengthening its own. The bank does the reverse in case the currency is too strong, it supplies foreign currency and demands its own currency.
Advantages
Stability is the major benefit of a fixed system. It provides certainty to those involved in international trade – importers and exporters know what the exchange rate would be in the future. This predictability can encourage trade and investment .
An additional benefit of fixed exchange rates is that they create a strong anchor to inflation. Having a stable currency such as the dollar or euro as the basis for both their own and other currencies helps them to import that stability and to develop confidence in their own monetary policy. The CFA franc, which is pegged to the euro and guaranteed by the French treasury, has assisted its member countries in keeping their inflation and financial stability low, for instance.
Disadvantages
The disadvantage is that the flexibility of the policy is lost. The central bank's foremost task is to safeguard the peg if it is its obligation, and it has to focus on the exchange rate. It is unable to take its own action using the monetary policy tool to solve problems at home such as unemployment or recession.
Good foreign exchange reserves are also necessary in maintaining a peg. When there is depletion of the country's reserves to defend the currency, it can be susceptible to a speculative attack, in which investors gamble that the currency will be devalued . The Nigerian case illustrates this as the central bank was forced to intervene in the market to buy huge quantities of dollars to support the naira's peg, which it was hard for an economy with a high dependence on imports to do.
A system of exchange rates based on the value of the currency at any given moment.
A floating exchange rate is one that is allowed to be determined by the forces of supply and demand in the foreign exchange market, with no direct intervention from the government or central bank.
How it works
When a currency is in demand, it will appreciate. When demand decreases, it decreases, and when demand increases it increases. Such moves are in line with the market's evaluation of the nation's economic performance, inflation rate, interest rates and political stability.
Advantages
A floating system gives the central bank independence. It can help direct monetary policy towards domestic objectives such as controlling inflation or boosting growth, instead of towards a target on the exchange rate. This is especially relevant for the large economies such as the U.S. and U.K. .
In addition, floating rates are automatically adjusted. A trade deficit, for instance, will lead to depreciation of a country's currency. This depreciation makes its exports less expensive (which makes them more competitive), and imports more expensive (which makes them less competitive), of course helping to correct the deficit.
Disadvantages
One of the disadvantages is volatility. Changes in exchange rates can also be erratic, in response to speculation or external factors, and therefore cause uncertainty for businesses and may impede cross-border trade. This is a major issue in countries with a highly trade dependent economy.
A system to manage the exchange rate Exchange rate management system.
Hybrid systems are a type of managed float or dirty float. The value of the currency is largely established by market forces, although the central bank may step in from time to time in order to keep the currency stable or move it in a specific direction.
How it works
This would enable a central bank to dampen the excessive short-term volatility, counteract disruptive trends or fend off any undue trend they feel is unjustified. But no clear path for the exchange rate is set. The intervention is usually on a case-by-case basis.
Advantages
It provides stability and flexibility. A managed float offers many of the advantages of a floating rate, but also gives the central bank a mechanism to intervene in times of extreme market stress, or some degree of independence in monetary policy. As an instance, the central bank of Nigeria has declared this is the system that it is at this time practicing.
Disadvantages
Intervention criteria are not always expressed; this can leave uncertainty for market participants . The risk is also that the central bank could intervene to support the exchange rate, which could not be sustainable in the long-term, and thus could deplete foreign reserves.
Which System Should You Use?
There is no universal best system. The decision is dependent on the country's particulars. Small open economies with large trade sectors are generally more willing to have fixed exchange rates to reduce exchange rate risk for their traders. High-inflation countries can anchor the value of their currency to a stable one to establish confidence .
Larger economies and those with different rates of inflation are more likely to choose floating or managed systems, to give the government flexibility in its policy actions. The free float may be even more volatile for developing countries with underdeveloped financial markets, which may justify a managed float .
Different African countries can provide an example of the performance of an exchange rate system. In a study of the five countries of Southern Africa (DRC, Malawi, Mozambique), it has been shown that the countries that had a more liberal floating regime or a managed floating regime (after the 1990s) experienced faster economic growth, than those that had a fixed regime (the 1960s to 1980s).
Finally, the selection of the best system for a country depends on how closely it fits its economic make-up and development objectives.
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