Flexible Exchange

Rate
ABOO BAKER MOHAMMEDI
TAHA MADANI
AHMED RAZA MUNAF
MOHAMMAD ABDULLAH

History

In 1821-1914 Most of the World's currencies were redeemable in to

gold. (i.e. you could "cash in your paper notes for predefined
weights of gold coin).

Britain was the first to officially adopt this system in 1821 and was
followed by other key countries during 1870s.

The result was a global economy connected by the common use of

gold as money.

Close to the end of World War II, the Bretton Woods Agreement was
signed. Since the impact of the Great Depression was still fresh in
the minds of the policymakers, they wanted to shun all possibilities
of a similar fiasco. The Bretton Woods Agreement founded a
system of fixed exchange rates in which the currencies of all
countries were pegged to the US dollar, which in turn was based on
the gold standard.

By 1970, the existing exchange rate system was already under

threat. The Nixon-led US government suspended the
convertibility of the national currency into gold. The supply of the
US dollar had exceeded its demand.

In 1971, the Smithsonian Agreement was signed. For the first

time in exchange rate history, the market forces of supply and
demand began to determine the exchange rate.

Difference between a fixed

and floating exchange rate?

Fixed Exchange Rates

A fixed exchange rate denotes a nominal exchange rate that is

set firmly by the monetary authority with respect to a foreign
currency or a basket of foreign currencies.

A set price will be determined against a major world currencies.

In order to maintain the local exchange rate, the central bank
buys and sells its own currency on the foreign exchange market
in return for the currency to which it is pegged.

Example

It is determined that the value of a single unit of local currency is equal to

US$3, the central bank must keep a high level of foreign reserves. This
reserved amount is held by the central bank to use to release (or absorb)
extra funds into (or out of) the market.

This ensures an appropriate money supply, appropriate fluctuations in the

market (inflation/deflation) and ultimately, the exchange rate. The central
bank can also adjust the official exchange rate when necessary.

Flexible Exchange Rate

By contrast, a floating exchange rate is determined in foreign

exchange markets depending on demand and supply, and it
generally fluctuates constantly. Also termed "self-correcting," as
any differences in supply and demand will automatically be
corrected.

Example: if demand for a currency is low, its value will decrease,

thus making imported goods more expensive and stimulating
demand for local goods and services. This in turn will generate
more jobs, causing an auto-correction in the market.

A fixed exchange rate regime reduces the transaction costs

implied by exchange rate uncertainty, which might discourage
international trade and investment.

On the other hand, autonomous monetary policy is lost in this

regime, since the central bank must keep intervening in the
foreign exchange market to maintain the exchange rate at the
officially set level.

However

In a fixed regime, market pressures can also influence changes in

the exchange rate. Sometimes, when a local currency reflects its
true value against its pegged currency, a "black market" may
develop. A central bank will often then be forced to revalue or
devalue the official rate so that the rate is in line with the
unofficial one, thereby halting the activity of the black market.

In a floating regime, the central bank may also intervene when it

is necessary to ensure stability and to avoid inflation.

In practice there is a range of exchange rate regimes lying between these

two extreme variants, thus providing a certain compromise between stability
and flexibility.

Managed Exchange rate is the hybrid system, not as flexible as the floating
rate and not as intervening as the fixed exchange rate. Just depends on how
much control the central banks wants.

Examples of Exchange Rate

Regimes

Exchange Rate Bands: Exchange rate bandsallow markets to set

rates within a specified range; endpoints are defended through
intervention. It provides a limited role for exchange rate
movements to counteract external shocks while partially
anchoring expectations. This system does not eliminate
exchange rate uncertainty and thus motivates development of
exchange rate risk management tools. On the margin a band is
subject to speculative attacks.

Crawling Peg: A crawling pegattempt to combine flexibility and

stability using a rule-based system for gradually altering the
currency's par value,typically at a predetermined rate or as a
function ofinflationdifferentials. A crawling peg is similar to
afixed peg, however it can be adjusted based on clearly defined
rules. Often used by (initially) high-inflation countries or
developing nations who peg to low inflation countries in attempt
to avoid currency appreciation.At the margin a crawling peg
provides a target for speculative attacks.

Managed Float: Managed floatexchange rates are determined in

the foreign exchange market. Authorities can and do intervene,
but are not bound by any intervention rule. Often accompanied
by a separate nominal anchor, such as inflation target. It overs
less transparency because of its reliance on the credibility of
monetary policies.

Pure Float: In apure float, the exchange rate is determined in the

market without public sector intervention. Adjustments to shocks
can take place through exchange rate movements. It eliminates
the requirement to hold large reserves.

Advantages

Flexible exchange rates as automatic stabilizers:

The monetary policy and growth performance of a country affect

exchange rates. For example, when foreigners demand for a
countrys exports declines, output also decline and the countrys
currency depreciates. This situation helps improve the countrys
export performance because depreciation makes the countrys goods
cheaper to foreigners

Independent Monetary Policy:

Under flexible exchange rate system, a country is free to adopt an

independent policy to conduct properly the domestic economic
affairs. The monetary policy of a country is not limited or affected by
the economic conditions of other countries.

Advantages

Promotes International Trade:

The system of flexible exchange rates does not permit exchange

control and promotes free trade. Restrictions on international trade
are removed and there is free movement of capital and money
between countries

Shock Absorber:

A fluctuating exchange rate system protects the domestic economy

from the shocks produced by the disturbances generated in other
countries. Thus, it acts as a shock absorber and saves the internal
economy from the disturbing effects from abroad.

Disadvantages

Inflationary Effect:

Flexible exchange rate system involves greater possibility of

inflationary effect of exchange depreciation on domestic price level
of a country. Inflationary rise in prices leads to further depreciation of
the external value of the currency.

Exchange rate risk:

The main disadvantage of flexible exchange rates is their volatility. In

the postBretton Woods era, one of the characteristics of flexible
exchange rate is their excess volatility. The changes in exchange
rates are more frequent and larger than the underlying fundamentals
imply.

Disadvantages

Volatile Capital Movements:

The system of fluctuating exchange rates leads to unnecessary

international capital movements. By encouraging speculative
activities, such a system causes large-scale capital outflows and
inflows, thus, seriously disturbing the economy of the country.

Widespread Speculation with a Destabilising Effect:

The system of flexible exchange rates has been opposed on the

ground that under it there is widespread speculation regarding ex
change rates of currencies which has a large destabilising effect on
these rates. Friedman, on the other hand, contend that speculation
has a stabilising influence on exchange rates.