Flexible and Fixed Exchange Rates
Countries with flexible exchange rates allow their currency to increase or decrease in value against other currencies, depending on its demand and supply relative to the demand and supply of other foreign currencies.
For instance, if the United States government supplies many more dollars than the French government supplies Euro to the world economy – for example through more expansionary monetary policy - then there would be an increase in the relative supply of dollars and a decrease in the relative supply of Euro. Consequently, other things equal (e.g. no other changes in demand), the price (value) of the dollar relative to the Euro would fall (or depreciate) and the price of the Euro relative to the dollar would rise (appreciate).
An increase in relative demand can also cause the currency to fluctuate. Assuming other variables do not change, a relative (to the Euro) increase in demand for U.S. dollars (for example, because of an increase in demand for American goods or financial assets) would increase the price (value) of the American dollar and would decrease the price of the Euro. The advantage of fluctuating exchange rates is that the rates are more likely to reflect the true underlying value of the currency thereby minimizing economic distortions.
Some countries prefer to keep their currency value fixed relative to other foreign currencies, regardless of prevailing demand and supply forces. Advantages of this system include more predictability for businesses engaged in international trade. Fixed exchange rates can also perform a useful role in anchoring inflation expectations in country that is determined to break with high inflation. The disadvantage is that countries typically find it difficult to ‘exit’ from pegged exchange rate regimes, even where the exchange rate has become clearly overvalued. In such a situation, central banks often intervene to defend the currency by selling foreign reserves. When central banks’ reserves become depleted, countries are often forced to break their exchange rate pledge and devalue their currency. This can lead to higher inflation and import prices – hurting the poor – and can damage the balance sheets of the government (by raising the foreign debt burden), banks (if they have more foreign liabilities than assets) and corporations (again if they have foreign liabilities unmatched by foreign income streams).
More and more developing countries have adopted floating or flexible exchange rate arrangements during the past fifteen years. Maintaining fixed exchange rates can cause a gradual erosion of competitiveness if domestic inflation is higher than that of trading partners (oftentimes the case for developing countries). Also with exports of many developing countries heavily dependent on a few commodities, flexible exchange rates can often play a useful buffer role.
Other exchange rate options
- Full dollarization: under this option, followed for example by Panama and Ecuador, the local currency is abolished and a foreign currency (in this case the US dollar) is adopted as the sole legal tender. Although this has the advantage of providing stability, certainty and low inflation (essentially US inflation) it also has several disadvantages. If a country’s trade is not heavily weighted in favor of the adopted currency, full dollarization may not be a suitable option. More generally, unless the country has very close ties with the parent country, adopting the parent’s monetary regime may not make much sense. Another disadvantage is that by abolishing domestic currency, countries give up their seigniorage or the profits from issuing currency at very little cost.
- Currency board: under currency board arrangements, a country retains its own currency but promises to exchange the domestic currency for a foreign currency at a fixed given rate. To back up this promise, central banks hold reserves at least equal to the domestic base money supply (so that the exchange promise can be fulfilled). Also to back up this promise, central banks allow money supply to be determined solely by foreign exchange inflows or outflows. Domestic credit expansion is prohibited under such a system, even for lender of last resort provision. By providing a stronger exchange rate commitment than regular exchange rate regimes, a well-run currency board can provide large advantages in terms of creditability and anchoring expectations. This is the case for instance in some small countries such as Hong Kong and Lithuania. At the same time, the ‘exit problem’ is intensified and can result in terrible economic consequences, as in Argentina’s forced exit from the currency board in 2001.
- Other: in practice, most countries adopt none of the corner solutions identified above. Few countries float freely (fail to intervene) and fixed rates rarely last long without some form of exit. So in actual practice many countries adopt dirty or managed floating exchange rate regimes, typically refraining from an intervention but using foreign exchange transactions on occasion when the market is thought to have strayed too far from equilibrium.
In the last few weeks we have examined the role of monetary and exchange rate policy. These policies can have a large impact on economic performance, especially in the short term, but, badly handled, they can also impede economic growth and hurt the poor. We began by examining the nuts and bolts of monetary policy operations and instruments, and describing how developing countries still use direct instruments of monetary control, including credit ceilings and interest rate controls. These types of policies can be highly distortionary and have been largely abandoned by industrial countries in recent decades, in favor of indirect monetary instruments. These instruments, also used by developing countries, include reserve requirements, central bank lending facilities and open market operations. We then discussed different inflation measures, different types of inflation and various causes. We saw that while excessively loose monetary policy can help in the short run, it comes at a cost of high and volatile inflation. It was shown in turn that low inflation is good for long-term growth and for poverty reduction. The discussion then focused on how the costs of inflation are borne most heavily by the poor. We have concluded with a brief analysis of exchange rate policy and the various exchange rate options open to policymakers, ranging from formal dollarization to freely-floating exchange rate regimes. The choice of an exchange rate regime depends on a country’s characteristics, including its inflation performance, monetary credibility, its trading patterns, and its vulnerability to shocks
Next week: Financial Development and Poverty