These are the slides from a revision presentation covering fixed and floating exchange rate systems.

1. Revision on Fixed and Floating
Exchange Rate Systems

2. Revision MC (1)

3. Revision MC (1)
Euro 1 buys 82.8 pence
82.8 pence = $1.375
£1 = $1.375/0.828 = $1.66

4. Revision MC (2)

5. Revision MC (2)
D2

6. Revision MC (3)

7. Trade weighted exchange rate index
New index = (110x80) + (150x20) / 100
(8800 + 3000) = 11800 / 100 = 118
Revision MC (3)

8. Revision MC (4)

9. Revision MC (4)

10. Classification of Currency Systems
• The choice of exchange rate regime is one of the most
important a country can make as part of monetary policy.
The main options are:
1. A free-floating currency where the external value of a
currency depends wholly on market forces of supply and
demand
2. A managed-floating currency when the central bank
may choose to intervene in the foreign exchange
markets to affect the value of a currency to meet
specific macroeconomic objectives
3. A fixed exchange rate system e.g. a currency peg either
as part of a currency board system or membership of
the ERM II for countries intending to join the Euro.

11. Classification of Currency Systems (December 2016)
Exchange Rate System Exchange rate anchor (where relevant)
US Dollar ($) Euro
Composite or Other
Currency Peg
Fixed currency with no
separate legal tender
Ecuador
Zimbabwe
Kosovo, San Marino
Currency Board System Hong Kong Bulgaria
Conventional exchange rate
peg (fixed currency system)
Bahrain
Qatar
Saudi Arabia
Denmark
Senegal
Kuwait
Nepal
Crawling exchange rate peg
(semi-fixed currency)
Jamaica Croatia
Botswana
China
Ethiopia
Managed floating currency
Kenya, Brazil, Ukraine, South Korea, India, Zambia, South Africa,
Thailand, Turkey, Sweden, Mexico, Israel, Japan, Chile
Free floating exchange rate Australia, Canada, Norway, UK, USA, Euro Zone

12. Denmark operates fixed exchange rate against Euro

13. Poland operates floating exchange rate against Euro

14. Free Floating Exchange Rates
• The strength of currency supply and demand drives
the external value of a currency in the markets
Currency value set by market forces
• Central bank allows the currency to find its own level
No intervention by the central bank
• External value of currency is not used as an
intermediate target of macroeconomic policy
No target for the exchange rate

15. Sterling Exchange Rate (as an index number)
70.0
75.0
80.0
85.0
90.0
95.0
100.0
105.0
110.0
115.0
120.0
02Jan14
02Feb14
02Mar14
02Apr14
02May14
02Jun14
02Jul14
02Aug14
02Sep14
02Oct14
02Nov14
02Dec14
02Jan15
02Feb15
02Mar15
02Apr15
02May15
02Jun15
02Jul15
02Aug15
02Sep15
02Oct15
02Nov15
02Dec15
02Jan16
02Feb16
02Mar16
02Apr16
02May16
02Jun16
02Jul16
02Aug16
02Sep16
02Oct16
UK Exchange Rate Indices, 2nd Jan 2014 = 100
Sterling ERI €/£ $/£
Source: Bank of England

16. The June 2016 Post-Brexit Sterling Depreciation
Daily post-Brexit currency exchange rates of Sterling (GBP) against the Euro (EUR) June 2016
1.15
1.17
1.19
1.21
1.23
1.25
1.27
1.29
1.31
1.33
June20
June21
June22
June23
June24
June27
June28
June29
June30
July1
July4
July5
July6
July7
July8
July11
July12
July13
July14
July15
July18
July19
July20
July21
Exchangerate
Sterling depreciated against the Euro following the Brexit vote. From
£1 buying Euro 1.31, the pound slipped to £1 buying Euro 1.17
before stabilizing.
Remember:
• A depreciation happens inside a floating exchange rate system
• A devaluation happens with a fixed exchange rate system

18. Currency Crisis - Turkey
• Political instability
(failed coup in 2016)
• Large current a/c deficit
• Investors get nervous –
capital flight intensifies
• Country exposed to
existing external debts
• More expensive to repay
when the value of the
currency falls
• Limited impact of
central bank
intervention
• Higher interest rates risk
causing a deep recession

19. Fixed Exchange Rates
• External value is pegged to one or more currencies
• The central bank must hold sufficient foreign exchange reserves in
order to intervene in currency markets to maintain the fixed peg
Government / central bank fixes currency value
• Trade takes place at this official exchange rate
• There might be unofficial trades in shadow currency markets
Pegged exchange rate becomes official rate
• Occasional realignments may be needed
• E.g. a devaluation or revaluation depending on economic
circumstances – the currency may have drifted from fundamental
value
Adjustable peg

21. Managed Floating Exchange Rates
• Central bank gives a degree of freedom for market exchange
rates on a day-to-day basis
Currency usually set by market forces
• Buying to support a currency (selling their FX reserves)
• Selling to weaken a currency (adding to their FX reserves)
• Changes in policy interest rates to affect “hot money flows”
Central bank may intervene occasionally
• Higher exchange rate to control inflationary pressures
• “Competitive devaluation” to improve competitiveness
Currency becomes a key target of monetary policy

22. Tools for Managing Floating Exchange Rates
• Changes in interest rates e.g. lower interest rates to depreciate the exchange rate
• Causes movements of “hot money” banking flows into or out of a country
Changes in monetary policy interest rates
• Increase liquidity in the banking system, usually causes outflow of money – depreciation
of the exchange rate
Quantitative easing
• Direct intervention in the currency market
• Buying and selling of domestic / foreign currencies
Direct buying / selling in the currency market (intervention)
• Taxation of foreign deposits in banks cut the profit from hot money inflows
• Controls on the free flow of capital into and out of a country
Taxation of overseas currency deposits and capital controls

24. Evaluating Floating Exchange Rates
Floating Exchange Rates
•Reduces need to hold large
currency reserves
•Freedom to set interest rates
to meet domestic objectives
•Insulation for an economy
after an external shock
especially for export-
dependent countries
•Partial automatic correction
for a current account deficit
•Less risk of a currency
becoming significantly
over/undervalued
Evaluation
• No guarantee that floating
exchange rates will be stable
• Volatility in a floating
exchange rate might be
detrimental to attracting
inward investment
• A lower (more competitive)
exchange rate does not
necessarily correct a
persistent balance of
payments deficit - consider
the J curve theory and also
the importance of non-price
competitiveness

25. Evaluating Fixed Exchange Rates
Fixed Exchange Rates
• Certainty of currency value gives
confidence for inward investment
• Reduced costs of “currency hedging”
for businesses
• Stability helps to control inflation –
i.e. it is a discipline on businesses to
keep their unit labour costs low
• Can lead to lower borrowing costs
(i.e. lower yields on bonds)
• Imposes responsibility on government
macro policies
• Less speculation if the fixed exchange
rate is credible
Evaluation
• Reduced freedom to use interest
rates for other macro objectives
• Many developing countries do not
sufficient foreign currency reserves to
be able to maintain a fixed exchange
rate
• Difficult for countries to use a
competitive devaluation of their fixed
exchange rate - creates political
tensions and might lead to a
protectionist response
• Devaluation of a fixed exchange rate
can lead to a surge in cost-push
inflation - damaging for
competitiveness and has regressive
effects on poorer families

26. @tutor2ugeoff

27. Revision on Fixed and Floating
Exchange Rate Systems