7.1 Fixed vs. floating exchange rate regimes

Exchange rate regimes shape global economics. Fixed rates offer stability for trade but limit policy flexibility. Floating rates allow market-driven adjustments but can bring volatility. The choice impacts monetary autonomy, inflation control, and economic shock absorption.

Countries consider factors like economic size, openness, and financial market development when choosing a regime. Historical shifts, from Bretton Woods to the Eurozone, show how exchange systems evolve with global economic conditions and crises.

Exchange Rate Regimes

Fixed vs floating exchange rates

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• Fixed exchange rate system pegs the exchange rate to another currency or a basket of currencies
• Central bank actively intervenes in the foreign exchange market to maintain the fixed rate requires sufficient foreign exchange reserves
• Floating exchange rate system allows the exchange rate to be determined by market forces of supply and demand without central bank intervention
• Exchange rate can fluctuate freely in response to economic conditions and market sentiment in a floating system

Pros and cons of exchange regimes

• Fixed exchange rates provide stability and predictability for international trade and investment (long-term contracts) reduces exchange rate risk for businesses
• Fixed rates can help control inflation by anchoring domestic prices to a stable currency (USD)
• Fixed rates require sacrificing monetary policy autonomy to maintain the peg can be vulnerable to speculative attacks (George Soros) if the peg is not credible
• Fixed rates may lead to misalignments between the exchange rate and economic fundamentals (overvaluation, undervaluation)
• Floating exchange rates allow for automatic adjustment to economic shocks and imbalances (oil price shocks) provides greater monetary policy autonomy
• Floating rates reduce the need for large foreign exchange reserves
• Floating rates can lead to exchange rate volatility and uncertainty for international trade (short-term fluctuations)
• Floating rates may be subject to excessive speculation and overshooting (bubbles) can amplify the impact of economic shocks on the domestic economy

Factors in exchange rate decisions

• Economic size and openness
  • Smaller, more open economies (Singapore) may prefer fixed exchange rates to reduce exchange rate risk
  • Larger, more closed economies (USA) may prefer floating exchange rates for greater policy autonomy
• Macroeconomic stability
  • Countries with high inflation or unstable macroeconomic conditions (Argentina) may prefer fixed exchange rates as a nominal anchor
  • Countries with stable macroeconomic conditions (Canada) may prefer floating exchange rates to absorb economic shocks
• Financial market development
  • Countries with less developed financial markets (African nations) may prefer fixed exchange rates to provide stability
  • Countries with more developed financial markets (Japan) may prefer floating exchange rates to facilitate market-based adjustment
• Political considerations like regional integration (Eurozone) or historical ties (former colonies) may favor fixed exchange rates
• Asserting monetary sovereignty and avoiding external constraints may favor floating exchange rates

Historical shifts in exchange systems

1. Bretton Woods system (1944-1971) had fixed exchange rates pegged to the U.S. dollar, which was convertible to gold
   • Breakdown of the system due to U.S. balance of payments deficits and overvaluation of the dollar
2. European Monetary System (1979-1999) had fixed exchange rates among European currencies through the Exchange Rate Mechanism (ERM)
   • Speculative attacks on weak currencies (Italian lira) during the 1992-1993 ERM crisis led to the widening of exchange rate bands
3. Asian financial crisis (1997-1998)
   • Many Asian countries (Thailand, South Korea) maintained fixed exchange rates pegged to the U.S. dollar
   • Speculative attacks and capital flight forced countries to abandon their pegs and adopt floating exchange rates
   • Significant economic contraction and financial instability followed the transition to floating rates
4. Eurozone (1999-present) adopted a common currency (euro) and a fixed exchange rate system among member countries
   • Eliminated exchange rate risk within the eurozone but reduced monetary policy flexibility for individual countries (Greece)
   • Challenges in addressing asymmetric economic shocks and debt crises without exchange rate adjustment tools