Critical Comparison of Fixed and Floating Exchange Rate Mechanisms

Topics: Monetary policy, Foreign exchange market, Bretton Woods system Pages: 8 (2472 words) Published: October 11, 2008
This paper will examine independently floating exchange rate arrangements and other conventional fixed peg arrangements in separate sections. Each section contains four parts: •An examination of the mechanics of the regime;

A discussion of its advantages and disadvantages;
An analysis of the experiences of selected nations and how these experiences highlight the strengths and weakness of the system; and •My final thoughts on that particular exchange rate regime. 1.Conventional fixed peg arrangements

a.Mechanics of conventional fixed peg arrangements
Fixed peg arrangements are recognized by the IMF as a fairly inflexible exchange rate regime. Countries in this category peg their currency, either formally or on a se facto basis, to another currency or a basket of currencies at a fixed rate. Such a basket would contain the currencies of major trading or financial partners which are weighted to reflect distribution of sales, services and cash flows. The exchange rate is allowed to fluctuate within limits one percent above and below the fixed central rate. It is the role of the nation’s monetary authority to maintain the fixed parity using either direct or indirect intervention. Direct intervention involves buying and selling the currency in the foreign exchange market, whereas indirect intervention involves the aggressive use of interest rate policy, foreign trade regulation or the intervention by other public institutions. b.Advantages and disadvantages of fixed peg arrangement

It is argued that fixed rates provide certainty for international businesses by eliminating foreign exchange risk which will encourage foreign investment and that fixed rates should eliminate destabilizing speculation. This is often seen as the most compelling endorsement of fixed rate regimes. However this argument is fallacious if the level of the peg is unsustainable. An unsustainable peg will lead to currency reserves being run down causing a currency crisis. Such circumstances were seen in the lead up to the Asian financial crises of the 1970s where the Thai baht was fixed to a basket of currencies at an unsustainable level and eventually went into freefall when as the balance of payments deficit became unmanageable. The example of Thailand also illustrates that fixed rates do not preclude speculation as the Thai baht was subject to fierce speculative bids especially by the George Soros’ Fund. Therefore a fixed peg arrangement will only be advantageous if the peg is appropriately set and extremely well managed by the government. Despite the exchange arrangements being rather inflexible, there still exists the possibility within fixed peg arrangements for traditional central bank functions as well as the opportunity for the adjustment of the exchange rate by the nation’s monetary authority. Although possible, adjustment of the exchange rate can only occur infrequently and not fast enough to appropriately respond to market forces. Often the exchange rate can dominate policy such that interest rates and other policies may be set to maintain the fixed rate without a great deal of consideration for what is best for the economy. A country which pegs its currency to another currency may not have the same monetary policy or inflationary conditions. If a nation with high inflation is pegged to a nation with lower inflation the high inflation country will be under constant pressure to remain competitive and may ultimately have to allow a devaluation of the currency. Speculative short selling of the currency will add further downward pressure. Such competitiveness can only be maintained in the short-term. Another disadvantage is that fixed exchange rate arrangements require large holdings of foreign exchange reserves. c.Experiences of countries with fixed peg arrangements

An examination of Zimbabwe illustrates the perils of fixed peg arrangements (see graph 1 below). Zimbabwe utilized money creation and the sale...

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De Grauwe, Dewachter and Embrechts, ‘Exchange rate theory’ (1993).
Fraser, B.W., ‘Australia’s recent exchange rate experience’ (1992). Talk by Governor Fraser to Association Cambiste Internationale Congress, Sydney, 29 May 1992.
Goldstein, Morris, ‘Adjusting China’s exchange rate policies’ (2004) Revised version of paper presented at the International Monetary Fund’s seminar on China’s foreign exchange system, Dalian, China May 26-27, 2004.
Classification of Exchange Rate Arrangements and Monetary Policy Framework – as of July 30, 2003 (2003) International Monetary Fund as at 30 August 2008.
De Facto Classification of Exchange Rate Regimes and Monetary Framework – as of July 31, 2006 (2006) International Monetary Fund as at 30 August 2008.
Lloyd and Sawyer ‘The Asian economic and financial crisis: the effects of market integrations and market fragility’ (1998) Melbourne Institute Bulletin.
Further work – the advantages and disadvantages of fixed exchange rates (2007) Biz/Ed at 30 August 2008.
Liew and Wu, ‘The making of China’s exchange rate policy: from plan to WTO entry’ (2007).
McKinnon, Ronald, ‘Why China should keep its exchange rate pegged to the dollar: a historical perspective from Japan’ (2006).
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