Fixed vs. flexible exchange rate regimes. Advantages, disadvantages, the choice of exchange rate arrangement.

1. Márton Zsolt

2. How it works
Brief historical overview
Choice of currency arrangement
Case study: China and the U.S.

3. How it works
Fixed exchange rate arrangement
“ 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.
(Scott D. L., 2003)

4. How it works

5. How it works

6. How it works

7. 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.

8. Brief historical overview
+ Appreciation of the USD
+ Massive inflation
+ Monetary shocks
+ Globalization
Transition from fixed to more flexible arrangements

9. Brief historical overview
In 1975, 87% of the world’s currencies were fixed.
Since then, this number has fallen well below 50%.

10. Choice of currency arrangement
Why do we need fixed rates in the first place?
• Gives small central banks more credibility
• Reduces volatility and sharp fluctuations in relative prices
• Eliminates exchange rate risk
• Good for exports

11. Choice of currency arrangement
Some disadvantages of fixed rates:
• 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

12. Choice of currency arrangement
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.

13. Choice of currency arrangement
Advanced economies
They are in the best position to
enjoy flexible rates
Emerging economies
May gain from a floating system

14. Choice of currency arrangement
Developing economies
Can gain credibility through
pegging

15. Choice of currency arrangement
Essential conditions for a fixed rate:
• 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)

16. Case study: China and the U.S.
The U.S. dollar vs. Chinese Yuan
June, 2010: China
promises to reform
its currency regime
8.27 CNY/USD peg Unofficial peg due to
the crisis