Fixed vs. flexible exchange rates

Márton Zsolt

Brief historical overview

Choice of currency arrangement

Case study: China and the U.S.

How it works

How it works

Fixed exchange rate arrangement

(Scott D. L., 2003)

“

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An exchange rate between currencies that is set by the governments involved rather than being allowed to fluctuate freely with market forces. (…) authorities actively enter the currency markets to buy and sell according to variations in supply and demand.

How it works

How it works

How it works

Brief historical overview

Bretton Woods

The major currencies began to float

Developing countries tried to maintain their pegs to the USD, French franc, Deutschmark, etc.

Brief historical overview

+ Appreciation of the USD

+ Massive inflation

+ Monetary shocks

+ Globalization

Transition from fixed to more flexible arrangements

Brief historical overview

In 1975, 87% of the world’s currencies were fixed.

Since then, this number has fallen well below 50%.

Why do we need fixed rates in the first place?

Choice of currency arrangement

• Gives small central banks more credibility

• Reduces volatility and sharp fluctuations in relative prices

• Eliminates exchange rate risk

• Good for exports

Some disadvantages of fixed rates:

Choice of currency arrangement

• Under-/overvaluation can build up and eventually lead to currency crises

• Can be expensive or even impossible to hold

• Black markets will emerge

• Does not reflect the true value of the currency

Economists disagree on whether the exchange rate has a long-term effect on growth or not

There is no “best answer” in all cases, every country is unique and has different needs

Factors that influence the choice are: level of development, size, openness, trading partners, etc.

Choice of currency arrangement

Advanced economies

Choice of currency arrangement

They are in the best position to enjoy flexible rates

Emerging economies

May gain from a floating system

Developing economies

Choice of currency arrangement

Can gain credibility through pegging

Essential conditions for a fixed rate:

Choice of currency arrangement

• Small and open economy

• The pegged currency belongs to a large trading partner (>50% of trade)

• The country wishes to pursue a macroeconomic policy that will result in an inflation rate consistent with that in the country

• The country is prepared to adopt institutional arrangements that will assure continued credibility of the fixed rate commitment

(Williamson, J., 1998)

The U.S. dollar vs. Chinese Yuan

8.27 CNY/USD peg Unofficial peg due to the crisis

June, 2010: China promises to reform its currency regime

Case study: China and the U.S.