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Fixed versus Flexible Exchange Rate Systems

Conference Paper · January 2011

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 INTERNATIONAL ACCOUNTING AND BUSINESS 2011
CONFERENCE
Fixed versus Flexible Exchange Rate Systems

Noorazlina binti Ahmad, Sakinah binti Mat Zin, Fadli Fizari bin Abu Hassan Asari
Universiti Teknologi MARA Terengganu, Malaysia
noora436@tganu.uitm.edu.my, sakin405@tganu.uitm.edu.my,
fizari754@tganu.uitm.edu.my

Abstract
Purpose – This paper shall focus on the comparisons of the fixed and flexible exchange rate systems
which are used by some countries. This paper shall elucidate the merits and demerits of the fixed and
flexible exchange rate systems and also evaluate the preferable exchange rate trend among Asian
countries.

Design/methodology/approach – Not relevan.

Findings – The choice of exchange rate regime can influence macroeconomic performance, inflation,
growth, international trade and it also a contributory factor to the stability of the international monetary
system.

Originality/value – There are several factors which can influence the exchange rate, namely - interest
rates, inflation, and the political and economic state of each country.

Keywords - Exchange rate; fixed exchange rate; flexible exchange rate; growth; inflation

Paper type – Concept paper

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Fixed Versus Flexible Exchange Rate Systems

1. Introduction

After the breakdown of the Bretton Woods system in the early 1970s, and the subsequent

adoption of the Second Amendment to the IMF’s Articles of Agreement all countries have been free

to adopt the exchange rate regime of their choice.

Many studies attempted by economists on the choice of an exchange rate regime. Mundell

(1961) highlights that a fixed exchange rate should be used as an indicator and not be a target of the

monetary policy since its impacts are on the development and maintenance credibility. In place of

fixed exchange rates as a tool for reducing inflation and exchange rate volatility is the establishment

of sound monetary institutions. According to Reinhart (2004) and Calvo and Reinhart (2002),

although there seems to be an observed shift in the world towards floating exchange rate regimes, the

“fear of floating” is persistent, and in practice, except for a few developed nations, the countries do

conduct policies to affect their exchange rates.

There are two basic types of exchange rate systems namely the fixed and flexible exchange rate

system. Government determines the exchange rate in the fixed exchange rate system, while in the

flexible exchange rate system the demand and supply force determine the exchange rate. Exchange

rate regimes are arranged into three categories according to their degree of flexibility:-

 Fixed-rate regimes - currency unions, dollarized regimes, currency boards and conventional

fixed pegs;

 Intermediate regimes – conventional fixed pegs, crawling pegs and crawling bands; and

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 Flexible regimes - managed and independent floats.

In an exchange rate regime where the currency's value is matched to the value of another single

currency or to a basket of other currencies, or to another measure of value, such as gold, it is known

as the fixed exchange rate or pegged exchange rate. While, the flexible exchange rate system is

where the exchange rate is determined by demand and supply force in the foreign exchange market.

It is a system in which the values of participating currencies are free to change in relation to one

another according to the market demand and supply for each currency.

For expositional purposes, a summary of the types of exchange rate systems are summarized below:

• Independently Float

The value of the exchange rate is determined by the demand and supply in the market, and the

monetary authority does not intervene for the purpose of affecting the value of the exchange rate.

Thus, the exchange rate does not restrict macroeconomic policies. Australia, Canada, Chile,

Colombia, the United Kingdom and the United States are examples of countries using free float.

• Managed Float

Other than the intervention of the monetary authority to contain volatility or to correct the long run

misalignment of the exchange rate, there is no specific exchange rate target and macroeconomic

policies are not restricted much by efforts to set the value of the exchange rate. Algeria had a

managed float as of the end of 2001.

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• Crawling Peg

The regular amendment of currency exchange (multiple times a year) is based on a procedure

known as the crawling peg. Its purpose is to adjust for swift inflation. Nevertheless, the exchange

rate for the currency would still be fixed between the alterations. Crawling pegs is also used where

there is a set path for the exchange rate and the target rate is adjusted frequently. Bolivia, Costa

Rica and Israel were among the countries that had some form of a soft peg by the end of 2001.

• Crawling Band

Between some predefined boundaries, the fluctuation of the exchange rate is permitted by the

Central Bank. It will buy or sell its currency in the exchange market at the top or bottom of the

band so that the rate will be within the limits of the band. This model is known as “operating a

fixed parity system under increasing pressure”. The exchange rate acts as a floating rate

mechanism since it fluctuates freely within the band. (Chris Brooks and Alejandro H. Revéiz,

2002)

• Conventional Fixed Peg

Under a fixed exchange rate system, the monetary authority fixes the value of the domestic

currency against a foreign currency or a basket of foreign currencies. Malaysia adopted a fixed

exchange rate regime in 1998.

• Currency Boards

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Under this system that restricts the conduct of monetary policy, the local currency is convertible to

the anchor currency on demand at a preset (by law) fixed exchange rate, and this is guaranteed by

backing the domestic monetary base with the foreign currency. In Argentina, a currency board

system was put into effect between 1991-2002.

• Dollarization or Eurozation

The country adopts U.S. dollars (or Euros) as the official currency. The examples of countries that

have adopted U.S. dollars as their official currency include Panama, Ecuador, and El Salvador.

• Monetary Union

This is an agreement by a group of countries to adopt a common currency and to have a common

central bank to conduct monetary policy for the whole group. Monetary policy can no longer be

used for the needs of individual members of the group. The European Union is an example of a

monetary union.

2. Empirical Literature

Exchange rate and export

The effect of exchange rate uncertainty to real variables in the macroeconomy, most notably

international trade has attracted much interest. Obstfeld and Rogoff (1995) note that, “many economists

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believe that exchange rate uncertainty reduces international trade” but it is not entirely clear, either

from a theoretical or an empirical standpoint that exchange rate uncertainty gives negative impacts on

trade. Sajjadur Rahman & Apostolos Serletis (2009) use aggregate data for the United States

economy, over the period from 1973 to 2007, and a dynamic multivariate framework in which an open

economy structural vector autoregression (VAR) has been modified to accommodate multivariate

generalized autoregressive conditional heteroskedastic (MGARCH)-in-Mean errors. They stress that

uncertainty of the exchange rate, is statistically and economically significant in affecting exports. They

also find in their investigation that accounting for uncertainty about exchange rate movements may

elevate the negative dynamic response of exports to a positive exchange rate shock.

Bacchetta and Van Wincoop (2001) adopt a general equilibrium framework that allows for

deviations from purchasing power parity to analyse the question of whether exchange rate stability

associated with a fixed exchange rate regime necessarily implies an increase in international trade.

Different with Either (1973), who finds that the level of trade is unrelated to exchange rate risk

when forward rates are taken as exogenous is example of early theoretical work regarding the question

of exchange rate uncertainty. Rafayet Alam (2010) finds that no causality runs from depreciation of

real exchange rate of Taka to export earning of Bangladesh. This result is in line with the findings of

Centre for Policy Dialogue and many other Bangladeshi researchers over the years, who found

Bangladesh’s export price inelastic and depreciation of Taka does not have much impact on export.

On the other hand, Vianne and de Vries (1992) highlight that exchange rate risk can be passed

onto the forward rate and thus, trade can be affected either positively or negatively

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Exchange rate and GDP

Besides indulging in several attempts to untangle the impact of large country interest rates on

domestic annual gross domestic product (GDP) growth, Neumeyer and Perri (2005) analyze the role of

fluctuations in domestic interest rates on the business cycle of small open economies, where the interest

rate is decomposed into an international rate and a country risk component. Reinhart, Carmen and

Vincent (2001) examine Group of Three (G-3) interest rate and exchange rate volatility by considering

a variety of North–South links. They find that the U.S. real interest rate affects growth in some

regions. Frankel and Roubini (2001) also discover a negative effect of G-7 real interest rates on less-

developed countries' output. These studies do not have space to consider in detail how major-country

interest rates and the domestic economy are connected since they consider many aspects of North–

South relations.

Moreover, many studies have use vector auto regressions (VARs) to explore the transmission of

international business cycles. Soyoung Kim (2001) has made a notable contribution by highlighting

that U.S. interest rates have an impact on output in the other six G-7 countries. The author examines the

potential channels through which the interest rate has an effect and finds no trade impact virtually and

that the impact on output comes from a reduction in the world interest rate. Referring to a study by

Flood and Rose (1995), there is a negative relationship between the exchange rate flexibility and output

variability. They stressed on the elevation of GDP volatility for fixed exchange rate countries as being

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forced to follow the base country's monetary policy even when it is not optimal for the domestic

economy.

On the other hand, Frankel and Romer (1999) have indirectly highlighted a notion that an

increase in trade has a significant positive effect on per capita income. Subsequently, Frankel and Rose

(2002) present evidence that trade benefits when exchange rates are stabilized. The implication derived

is that membership in a currency union may elevate trade with other union members.

On the contrary, there is no relationship between annual real GDP growth and the base interest

rate in countries without a fixed exchange rate. However, the countries with a fixed exchange rate grow

0.1 to 0.2 percentage points would be slower when base interest rates are 1 percentage point higher

(Julian di Giovanni and Jay C. Shambaugh, 2008). These situations emerge in a wide variety of

controls and specifications namely, controlling for time, region, income, base country GDP growth, and

others. Moreover, pegged countries will only respond to the rate of the country which they peg and not

to any world interest rate.

3. Fixed or Flexible Exchange Rate

During the nineties, many developing countries have made a decision to switch their pegging

arrangement from a single currency to a composite basket of currencies. The situation has been

prompted partly by the desire to minimize the adverse effects on their economies from fluctuations in

the exchange rates of major currencies. The fluctuations have taken place since the advent of

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generalized floating in 1973 and particularly in the 1980s. Developing countries rely significantly on

more flexible arrangements under which the adjustment of exchange rate is frequent. These

arrangements are often officially known as “adjusting to indicators,” “managed floating” or

“independently floating”. However, these terms do not accurately reflect the arrangements in place, as

the exchange rate is effectively set by the authorities in a substantial majority of cases, despite frequent

adjustment.

A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is

pegged to resulting in easier and more predictable trade and investments between the two countries and

is beneficial for small economies in which external trade forms a substantial part of their GDP. It can

also be used as a way to control inflation but, the currency pegged to the reference value follows the

rises and falls of that currency. Moreover, in order to attain macroeconomic stability, a fixed exchange

rate prevents a government from using domestic monetary policy in situation whereby its capital

mobility is perfect. This theory is in accordance to the Mundell-Fleming model.

One main benefit of a flexible exchange rate is that it frees monetary policy from the burden of

maintaining the exchange rate and thus allowing it to be a domestic stabilization mechanism. In

addition, compared to any other markets, the foreign exchange market is considered as the place where

risk can be easily traded and covered at a cheaper cost as long as there are sticky goods prices and

wages. Table 1 below shows the merits and demerits for fixed and flexible exchange rate system.

Table 1: Summary of merits and demerits of fixed and flexible exchange rate system.

Fixed Exchange Rate Flexible Exchange Rate

Merits Demerits Merits Demerits
If real exchange rate The competitiveness and Besides enjoying strong In spite of low risk for
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overvaluation and loss of undermines growth growth in the years overvaluation, there
competitiveness can be performance would leading up to the present would be failure in
avoided, inflation or emerge from exchange crisis, significant external delivering low inflation,
growth performance rate overvaluation. imbalances would be reducing volatility, or
would be controlled. created. There would also upgrade trade integration.
be an elevation of the
vulnerability to abrupt
and disruptive adjustment
and potential limitation
for countercyclical
macroeconomic policies.

In line with foreign direct If the exchange rate is set In keeping the current The appreciation of the
investment, the lower real wrong, it might be hard account balanced, the currency can make the
exchange rate volatility, for export companies to floating exchange rate unemployment problem
the greater “stable” forms be competitive in foreign would adjust itself. worse especially for the
of capital flows. countries. This is due to country that has excessive
the fact that it not easy to unemployment and a
fix the exchange rate as tendency toward surplus.
there are many variables In addition, there would
that keep changing. be a loss of export
Greater crisis competitiveness when a
susceptibility would incur currency’s value rises.
a cost of more rigid
exchange rate regimes.

Provides a useful There will be greater Emerging market Elevation of foreign

commitment device for impact on output and countries and developing exchange volatility can
the central bank to anchor economic activity because countries should opt cause serious problems,
expectations by the real exchange rate freely floating exchange especially in emerging
disciplining policies, it does not adjust. Hence, rates in order to become economies.
also limits the potential to larger deficits will be more financially
respond to more rapid. integrated. If a country has higher
macroeconomic shocks. inflation rate than others,
the export of the country
would be less competitive
and its imports more
expensive. The alleviation
of the exchange rate could
lead to even higher import
prices of goods due to
cost-push inflation. All in
all, inflation might drive
the uplift of whole
inflation rate.

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4. Conclusion

Each alternative of exchange rate arrangement would have different implications for the extent to

which national authorities participate in the foreign exchange markets. Recently, fixed exchange rate is

not the ultimate preference. Many developed and developing Asian countries have adopted the

exchange rate system. Countries like Indonesia, Philippines, Argentina, Australia, U.S., Bangladesh,

India, Taiwan, South Korea, Peru, Pakistan, New Zealand, Chile, Canada, Brazil are using independent

float exchange rate. While, Malaysia, China, Thailand, Cambodia, Singapore, Romania, Mexico, Japan,

Bolivia are among Asian countries that opt for managed float exchange rate. Vietnam is using crawling

peg, Israel, crawling band and Iran is adopting conventional fixed peg. Saudi Arabia, Hong Kong,

Macau, Sweeden are implementing currency board. Jordan and France are using Dollarization or

Eurozation. All types of exchange rate will give major implications to the countries adhering to it either

to the economic growth, international trade, inflation rate and others. Specific economic and political

factors must be taken into account in choosing any exchange rate arrangement. As such, by

understanding these factors comprehensively, wise policy suggestions or predictions would be

generated. Hence, it is up to the said countries to opt for an exchange rate regime that they find to

benefit their countries most.

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REFERENCES

Bacchetta, Philippe & van Wincoop, Eric (2001). Does Exchange Rate Stability Increase Trade and
Capital Flows? CEPR Discussion Papers with number 1962.

Calvo, G.A., Reinhart, C.M., (2002). Fear of Floating. Quarterly Journal of Economics CXVII (117),
pp. 379-408

Chris Brooks, and Alejandro H. Revéiz (2002). A Model for Exchange Rates with Crawling Bands—An
Application to the Colombian Peso. Journal of Economics and Business
Volume 54, Issue 5, September-October 2002, pp. 483-503

Either, W. (1973). International Trade and the Forward Exchange Market. American Economic
Review, 63, pp. 494-503.

Frankel, Jeffrey A and Andrew Rose (2002). An Estimate of the Effect of Currency Unions on Trade
and Growth. Quarterly Journal of Economics, 117(2), pp. 437-466.

Frankel, J. and D. Romer (1999), "Does Trade Cause Growth?," American Economic Review, Vol. 89,
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Frankel, Jeffrey A., Roubini, Nouriel, (2001). The Role of Industrial Country Policies in Emerging
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Soyoung Kim, (2001). International Transmission of U.S. Monetary Policy Shocks: Evidence From
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Reinhart, C.M., Rogoff, K.S., (2004). The Modern History of Exchange Rate Arrangements: A
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