How a Fixed Exchange Rate System Works

How a Fixed Exchange Rate System Works

High Capital Mobility:

Begin by distinguishing among two different economic environments in which a fixed exchange rate system works. The first is an environment of extremely high capital mobility similar to the situation the advanced industrial countries face today. Foreign exchange speculators buy as well as sell bonds denominated in different currencies with a few presses on a keyboard. Hot funds flows around the world nearly instantaneously in response to differences in expected rates of return. Governments find themselves in huge part dancing to the tune called by international currency speculators.

The subsequent is an environment of lower capital mobility. The capability of individuals in one country to invest their money in a second is low and limited and the flows of capital out of one country into another are limited. And governments that are eager to do so can shift the exchange rate for a time by using their foreign-exchange reserves to intervene in the foreign-exchange market.

A fixed exchange rate is an obligation by a country to buy and sell its currency at fixed and unchanging prices in terms of other currencies. To accomplish this commitment the country’s central bank and Treasury must maintain foreign exchange reserves. If people come to your central bank or else Treasury under a fixed exchange-rate system wanting to exchange dollars for pounds sterling or gold bars, the central bank or Treasury should have the pounds sterling or the gold bars to trade to them.

However the foreign exchange reserves of a country are limited. With today's elevated degree of capital mobility there are a great many potential foreign-exchange speculators out there in the wide world. All of them are looking for to make sure that they have their wealth invested in the place that offers the highest expected return. Their conclusions about where to invest their money are the result of a delicate balance between greed and fear and all the foreign exchange reserves a government has can’t materially alter the balance of foreign exchange supply as well as demand for more than a day or two. In high capital mobility countries' foreign exchange reserves are all but irrelevant. The real exchange rate is set by the similar exchange-rate equation we have seen before as greed balances fear in the mind of the typical foreign exchange speculator:

ε = εo - εr ( r - rf)
 
Keep in mind in this equation ε0 is foreign exchange speculators’ viewpoint about the long-run equilibrium value of the real exchange rate. r-rf is the difference between home and foreign real interest rates. εr is a parameter that notifies at what point fear balances greed: it tells how greatly extra foreign exchange speculators would be willing to bid up the value of dollar-denominated assets if there were an extra one percentage point per year interest rate differential in favor of assets denominated in dollars. The higher the interest rate discrepancy in favor of the home country the lower is the exchange rate (which you recall is defined as the value of foreign currency).

Why should this equation for the exchange rate hold? Suppose that the government sets a fixed parity such that the fixed value of foreign currency ε* is lower than given by the equation above. Foreign exchange speculators observe foreign currency as a bargain. The extra interest return as well as potential capital gain from appreciation they get from investing their money in foreign currency-denominated assets more than offsets any risks. Therefore foreign exchange speculators come to the government to sell it the (overvalued) home currency and purchase from it the (undervalued) foreign currency at the fixed exchange rate parity. The government uses down its reserves buying its own currency in exchange for its stocks of other countries’ currencies and of gold: it is a fixed exchange rate system finally.

The next day or hour, or minute the foreign exchange rate speculators do it once more. And yet again. The government speedily runs out of reserves. When its reserves are departed it can no longer buy as well as sell foreign currency for domestic currency at the fixed exchange rate parity for the reason that it no longer has any foreign currency or gold to sell. How long does this process take? In high capital mobility in hours or else days. There are plenty of potential foreign exchange speculators. They are all enthusiastic to profit by betting against a central bank especially a central bank that is carrying out its exchange transactions not for economic however for political reasons.

Therefore if the government wants to keep the exchange rate at ε*, its central bank should set interest rates thus that the equilibrium value of the exchange rate produced by the equation:

ε = εo - εr (r -rf)
     
Corresponds to the desired fixed exchange rate value ε*.

In order for this equation to grasp the central bank should set the domestic real interest rate r to:

892_domestic real interest.jpg

Monetary policy no longer is able to play a role in domestic stabilization: you can’t ask the central bank to lower interest rates to fight unemployment or increase interest rates to fight inflation because the interest rate is already devoted to maintaining the fixed exchange rate system. In a fixed exchange-rate system with high capital mobility not macro-economic policy makers however international currency speculators determine the exchange rate.

Barriers to Capital Mobility:

Now turn to the next case of lower capital mobility. Presume that there are sufficient barriers to international financial flows that it is difficult as well as costly to move money across national borders. The government’s foreign-exchange reserves are substantial relative to flows of capital. Capital mobility today is inadequate for many developing countries with thin financial markets. Capital mobility was partial for all countries only a few decades in the past. Capital mobility perhaps limited in the future as well either as future governments impose explicit controls on kinds of transactions or as small taxes on international transactions levied by future governments put sand in the wheels of international finance.

If capital mobility is small the rate at which the government buys or else sells its currency for foreign exchange has an impact on foreign exchange supply as well as demand and thus on the current exchange rate. The exchange rate is resolute by foreign currency speculators’ expectations, interest rate differentials as well as also by the speed at which the government is accumulating or spending its foreign exchange reserves R:

ε = εo - εr x ( r - rf) + εR x ΔR

A change ΔR in foreign exchange reserves increases the value of the exchange rate by an amount equal to the slope of a demand parameter εR times the change in reserves. When the government is gathering reserves the value of foreign currency is higher than it would otherwise be- the government is in their buying foreign currency raising the demand. When the government is expenses reserves the value of foreign currency is lower than it would otherwise be.

With Limited Capital Mobility a Central Bank Can Shift the Exchange Rate by Spending Reserves:

299_exchange rate by spending reserves.jpg

In such barriers to capital mobility the central bank regains some freedom of action to utilize monetary policy for domestic uses. It doesn’t have to directly as well as immediately transmit adverse shocks to foreign exchange speculator confidence or to foreign interest rates to the domestic economy in the form of higher interest rates and a recession. As loans as it has reserves it is able to choose to let them run down for a while rather than raising domestic interest rates. The domestic interest rate r isn’t:

362_domestic real interest.jpg

Instead it is:

735_domestic interset rate.jpg

However the amount of freedom of action for monetary policy is limited by the sensitivity of exchange rates to the magnitude of foreign-exchange market interventions performed by the central bank as well as by the amount of reserves. The level of foreign-exchange reserves should be positive:

R ≥ 0
     
Policies that spend reserves can’t be continued forever for the reason that once the government’s foreign-exchange reserves have fallen to zero it can no longer finance interventions in the foreign exchange market. (Note nevertheless that reserves can be replenished if they drop dangerously close to zero. That is what loans as of the IMF or from other major economy central banks are for.)


The Choice of Exchange Rate Systems:

Economists either applaud or else deplore the breakdown of the Bretton Woods system and the resort to floating exchange rates depending on their underlying philosophy. For a few like Nobel Prize-winner Milton Friedman the exchange rate is a price. Economic freedom as well as efficiency requires that prices be set by market supply and demand. They must not be set by the decrees of governments. Therefore the replacement of the fixed exchange-rate administered-price Bretton Woods system by the floating exchange-rate market-price system of today is a extremely positive change.

For others similar to Nobel Prize-winner Robert Mundell the exchange rate is the value that the government promises that the currency it issues will have. A steady exchange rate means that the government is keeping the contract it has made with investors in foreign countries. To let the exchange rate hover is to break this contract and everyone knows that markets only work if people don’t break their contracts. Therefore the replacement of the fixed exchange-rate administered-price Bretton Woods system by the floating exchange-rate market-price system of today is a extremely negative change.

I believe that the right answer is it depends. High philosophy is all extremely well however what should really matter is how the choice of an exchange rates regime affects the economy.

Benefits of Fixed Exchange Rates:

In a floating exchange rate system exporters and firms whose products compete with imported goods never know what their competitors' costs are going to be. Exchange rate-driven variations in the costs of their foreign competitors are an extra source of risk and businesses don’t like unnecessary risks. The fact that exchange rates vary discourages international trade and makes the international division of labor less sophisticated than it would otherwise be. Fixed exchange rate systems evade these costs. Fixed exchange rate systems support international trade by reducing exchange rate fluctuations as a source of risk. They evade the churning of industrial structure the pointless and inefficient shift of resources into and out of tradable goods sectors as the exchange rate fluctuates around its fundamental value. That is a significant advantage. That benefit was behind the decision of nearly all western European countries at the start of 1999 to form a monetary union- to fix their exchange rates against each other irrevocably therefore that even their national currencies will eventually disappear.

Fixed exchange rate systems evade some political vulnerability as well. Large exchange rate swings are an influential source of political turmoil. This political turmoil is evaded by fixed exchange rate systems.

Costs of Fixed Exchange Rates:

Under fixed exchange rates monetary policy is firmly constrained by the requirement of maintaining the exchange rate at its fixed parity. Interest rates that are too little for too long exhaust foreign exchange reserves and are followed either by a sharp tightening of monetary policy or by an abandonment of the fixed exchange rate. A floating exchange rate permits monetary to concentrate on maintaining full employment and low inflation at home on attaining what economists call internal balance. By contrast in a fixed exchange rate system the level of interest rates must be devoted to maintaining external balance--the fixed exchange rate. And fixed exchange rates have the drawback of rapidly transmitting monetary or confidence shocks- interest rates move in tandem all across the world in response to shocks. The central bank should respond to any shift in international investors' expectations of future profitability or future monetary policy by shifting short-term interest rates.

This is the cost-benefit computation facing those who have to choose between fixed and floating exchange rates. Is it more significant to preserve the ability to use monetary policy to stabilize the domestic economy rather than dedicating monetary policy to maintaining a constant exchange rate? Or is it more significant to preserve the constancy of international prices and therefore expand the volume of trade and the scope for the international division of labor?

Canadian economist Robert Mundell set out the terms in which fixed exchange rates would be a better system that floating ones with his concept of an optimal currency area. The manner Mundell put it the main reason not to have fixed exchange rates was that floating exchange rates allowed adjustment to shocks that affected two countries differently. This advantage would be worth little if two countries suffered the same shocks and reacted to them in the same way. This benefit would as well be worth little if factors of production possessed high mobility- then the effects of shocks would be transient because labor and capital would rapidly adjust as well as the benefits from different policy reactions to economic shocks would be small.

Currency Crises:

The East Asian Crisis of 1997-1998:

Two as well as half years after the beginning of the Mexican crisis the third international financial crisis of the 1990s hit the world economy. For twenty years prior to 1997 the economies of the East Asian Pacific rim had been the fastest-growing economies the world had ever seen. However in mid-1997 foreign investors began to worry about the long-run sustainability of the East Asian miracle as well as began to change their opinions of the fundamental long-term value ε0 of East Asia's exchange rates.

In Malaysia, South Korea, Thailand and Indonesia the values of their currencies fell and once again falling currency values caused a further swing in foreign exchange speculator expectations of the long-run exchange rate fundamental ε0. Indonesia was hit the most horrible with real GDP falling by one-sixth in 1998; with the Indonesian currency the rupiah losing three-quarters of its nominal value against the dollar as well as with short-term real interest rates rising to 30 percent as well as nominal interest rates rising to 60 percent.

Once foreign exchange speculators starts lowering their estimates of the long-run value of investments in East Asia other deeper problems in the Asian economies became apparent and were magnified. As East Asian exchange rates cut down it became clear that several of East Asia's banks and companies had borrowed heavily abroad in amounts denominated in dollars or yen. They had utilized those borrowings to make loans to the politically well-connected or to make investments that turned out not to be profitable in the long run.

Exchange Rates During the Asian Currency Crisis:

The reality that East Asia's financial system was based on close links between banks, governments and businesses and that it was extremely difficult to get financial accounts out of any East Asian organization increased fear that more East Asian banks as well as companies were bankrupt than had been thought. This caused a further raise in foreign-exchange speculators' views of the long-run exchange rate fundamental.

The vicious circle continuous Every loss of value on the part of the exchange rate increased the burden of foreign-denominated debt as well as increased the likelihood of general bankruptcy. Every increase in the perceived burden of foreign denominated debt caused a further loss of value on the part of the exchange rate. Poor banking-sector regulation had created circumstances in which a small initial shock to exchange rate confidence could produce a major crisis. The shorter-term the debt detained by a country and its citizens the more easily could capital flee and the larger was the impact of the crisis.

As the Asian disaster developed the IMF stepped in with substantial loans to boost foreign exchange reserves made in return for promises to get better banking-sector regulation and reform the financial system. The expect was that short-term loans would allow East Asian economies to avoid catastrophe until the pendulum of Wall Street expectations began to swing back. The expectation proved sound. Since mid of 1998 investors in New York and elsewhere have remembered that East Asia's economies had been the fastest-growing in the world in the previous generation as well as were in all likelihood good places in which to invest.

We are able to see the exchange-rate equation:

ε = εo - Φ (r - rf)
 
As offering a country a menu of choices for its value of the real exchange rate ε and its value of the domestic real interest rate r. The elevated the domestic real interest rate r, the more appreciated is the exchange rate the lower is the value of ε the real domestic-currency price of foreign exchange. If for some of a large number of possible reasons international investors suddenly lose confidence in the future of a country’s economy- their assessment of the exchange rate fundamental ε0 suddenly as well as massively depreciates.

Thus the menu of choices that a country has for its combination interest rate r and exchange rate ε suddenly deteriorates. If the interest rate r is to stay unchanged the exchange rate should depreciate the value ε of the real home currency price of foreign exchange must rise by a lot. If the exchange rate ε is to remain unchanged then the domestic real interest rate r must rise by a lot. Increase interest rates appear unattractive because it will create a recession. No domestic use would be served by such a recession- it is just the result of foreign investors’ change of opinion.

Therefore letting the exchange rate depreciate would seem to be the natural the inevitable policy choice. A sudden terror by foreign-exchange speculators is a sudden fall in demand for your country's products- international investors are no longer willing to hold your country’s bonds at prices as well as interest rates that they were happy at last month. What does a business firm do when the entire of a sudden demand for the products it makes falls? The firm cuts its price. May be a country faced with a sudden fall in demand for the products it makes must do the same- it should cut its price. And the simplest way for a country to cut its price is to let its exchange rate depreciate. As well as such a depreciation of the exchange rate would in fact tend to stimulate exports and production.

Yet during the 1990s whenever international investors have unexpectedly turned pessimistic about investing in a country observers have reacted with shock as well as horror when the exchange rate depreciates. Policy makers have sought to reduce the depreciation of the exchange rate. Observers have squeezed their hands over such an economic catastrophe. This was the anecdote in the collapse of the European Monetary System in 1992 the collapse of the Mexican peso in 1994-5 as well as the East

Asian financial crisis of 1997-8:

In all these cases the trigger of the disaster was a sudden change of heart on the part of investors in the world economy's industrial core in Frankfurt, New York, London and Tokyo. In Mexico in 1993 international investors poured a few $25 billion into the economy in Mexico in 1995 even though the peso had been devalued by two-thirds, Each piece of property and every business in Mexico was therefore three times cheaper as well as the country was the same country international investors took perhaps $10 billion out of the country. In East Asia in 1996 international investors poured maybe $70 billion into the region's economies and in 1998 the net private capital flow was about -$40 billion.

Economists will long disagreement whether it was the relative optimism of investors before the crisis or the relative pessimism of international investors subsequent to the crisis that was the irrational speculative wave. The right answer is perhaps yes- financial markets were excessively enthusiastic previous to the crisis and were excessively pessimistic afterwards.

However why such did changes in international investor sentiment cause a crisis rather than an embarrassment? Why not let the exchange rate depreciate as well as keep domestic monetary and fiscal policy aimed at maintaining internal balance?

The answer appears to be that large scale depreciation is tremendously dangerous your businesses, banks and governments have borrowed massively abroad and have done so not by promising to pay back their creditors in your home currency however by promising to pay back their creditors in foreign currencies- yen or dollars or Euros or pounds. Then a reduction of the exchange rate bankrupts the economy- the foreign-currency value of all the foreign-currency as well as businesses' assets are halved by the depreciation while the dollar value of their liabilities is unchanged. Such an interlinked chain of universal bankruptcies destroys the economy's ability to transform household savings into investment expenditures. It shifts the IS curve far as well as fast back to the left immediately as the chain of bankruptcies caused by deflation shifted the IS curve far fast back to the left during the 1930s- such chains of bankruptcies are the stuff of which Great Depressions are made.

Furthermore such a situation appears to arise the majority easily in the context of a fixed exchange rate. If the exchange rate is permanent for the moment no one seems to worry that much about what currency loans are denominated in- finally the exchange rate doesn’t change so six of one is half a dozen of the other. This possibly the most damaging Achilles heel of fixed exchange rate systems in our day- the knee-jerk belief that the system will continue indefinitely allow people to ignore important sources of risk that in currency crises have disastrous consequences.

Therefore there are some things that should surely have been done to reduce vulnerability to a crisis. Powerfully discourage tax borrowers from borrowing in foreign currencies. If you are going to accept free international capital flows (in an attempt to employ foreign financing for your industrial revolution) then are sure that your exchange rate can float without causing trouble for the domestic economy. If your exchange rate should stay fixed (for inflation-fighting or other reasons) then recognize that an significant part of keeping it fixed are controls over capital movements.

However once the crisis has hit good options are rare. As we observe above not depreciating the exchange rate is no solution. To avoid depreciation interest rates should rise. And high interest rates choke off investment as well as cause recession as well.

Therefore is there a possible path to safety? Can you elevate interest rates enough to keep the depreciation from triggering bankruptcy as well as hyperinflation while still avoiding a high interest rate-generated recession? Can you downgrade the exchange rate far enough to restore demand for home-produced goods without depreciating it so far as to bankrupt local businesses and banks?

Maybe.

The quandaries are real. It is economic policy misconduct to claim that it is observable that in financial crisis interest rates must not be raised and the exchange rate allowed finding its own panicked-market level even if banks and firms have large foreign-currency debts. It is economic policy malpractice to assert that in a financial crisis interest rates must be raised high enough to keep the exchange rate from falling at all. It is not that easy.

So if sudden changes of opinion by international investors cause so much trouble should not we keep such sudden changes of opinion from having destructive effects? Should not we use capital controls as well as other devices to keep international flows of investment manageable, small and firmly corralled? Should not we as ruler Mahathir Muhammed did in Malaysia impose capital controls?

Once again maybe.

The first generation of post-World War II economists the John Maynard Keynes with Harry Dexter White and their students would have said yes, of course. Unexpected changes of opinion on the part of international investors can source enormous damage to countries that permit free movement of capital. Such unexpected changes of opinion are a frequent fact of life. So make it illegal or at least highly restricted to borrow from as well as lend to invest in or withdraw investments from foreign countries.

The second as well as third generations of post-World War II economists had a different view. They are apologetic that capital controls kept people with money to lend in the industrial core away from people who could make good use of the money to expand economic growth. The balance of view shifted to the view that too much was sacrificed in economic growth at the periphery for whatever reduction in instability capital controls produced. Furthermore a regime of capital controls encouraged production. Frequently it was the cousin of the wife of the vice-minister of finance who received permission to borrow abroad. Therefore capital controls paved the way to kleptocracy- rule by the thieves.

Consequently today we have the benefits of free international flows of capital. The ability to borrow from abroad does assure to give successful emerging market economies the power to cut a decade or two off of the time it would take for them to industrialize. It assures to give investors in the world economy’s industrial core the opportunity to earn higher rates of return. However this free flow of financial capital is also giving us one major international financial crisis every three years.

What is to be done will be one of the main economic policy debates of the next decade. Must we try to move toward a system in which capital is even more mobile than it is today however in which international financial crises may become an even more common occurrence? Or must we try to move toward a system in which capital is less mobile more controlled and in which some of the benefits of international investment are traded away in return for fewer vulnerability to financial crises? We don't have to have a global economy as susceptible to currency crises as the economy of the 1990s has been.

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