Fixed Exchange Rate and Floating Exchange Rate Video Lecture - Economics

hi there in this topic video we're going
to be focusing on floating and fixed
exchange rates the choice of exchange
rate regime or system is one of the most
important that the country can make as
part of their monetary policy so we're
going to explore the difference between
floating and fixed exchange rates and
also look at manage floating as well so
first of all floating exchange rates in
a floating system the external value of
a currency depends wholly on market
forces of supply and demand no
intervention in the currency markets by
the central bank central bank allows the
currency to find its own level and
crucially the external value of the
currency example the value of the pound
against the dollar is not a target of
macri current policy as a floating
exchange rate also countries still have
free floating exchange rates or pretty
close to it the UK has a floating
exchange rate so to the Australian
dollar and usually lend and also in
Poland there's lotty
so Poland is inside the European Union
but it's outside the single currency at
the moment it has a floating exchange
rate here's a good example of a floating
exchange rate in action so the value of
sterling against the US dollar
notice how sterling fell or depreciated
more than 20% in 2008 through 2000-2009
it will cover a little bit of ground and
fluctuated around one dollar 55 one
dollar sixty for several years
floating currencies don't have to be
volatile but in recent times the pound
has been a falling depreciating against
the dollar dollars been appreciating so
the pound has gone down from about one
dollar seventy down to around one dollar
40 as we speak now in a managed floating
system a managed floating currency
system most of the time day to day the
currency is set by the markets by the
foreign exchange dealers so the central
bank will give the currency a degree of
freedom to move on a day to day basis
however occasionally some currency
market intervention might be considered
by the central
as part of a demand management strategy
so for example they might decide they
want the currency to go up which case
they will go into the market and start
buying their own currency and selling
foreign currency reserves they may
decide on the other hand that the
economy needs a lower currency perhaps a
depreciation to raise exports well this
can happen if they went into the market
and sold to their currency and bought
for an exchange in return in a managed
floating system the central bank can
also use changes in interest rates
because we know that the relative
interest rates on bank deposits is a
factor causing inflows and outflows of
of hot money now in a managed floating
exchange rate system the exchange rate
becomes a target of policy that's seen
as being instrumental and just shifting
the economy in a particular direction so
a country that wants for example to get
inflation down might favour a an
appreciation of the currency a country
that has a trade deficit and maybe a
recession or a deflation problem might
try to to bring their currency down and
value that's managed flirting and
increasingly we see country is moving
towards managed floating particularly
developing countries who want to
manipulate their currency in a
particular way
the Brazilian Leon is a managed currency
in the Swiss franc Japanese yen there's
going to be an following up on omics
Norwegian kroner and the study from
Ghana increasingly countries are moving
towards managed floating exchange rates
here because our blood for a currency
that's managed the Swiss actually
basically kept her or try to maintain a
more or less a fix against the euro from
around 2011 a lot of months of that two
year food to the end of 2014 can really
difficult though to maintain up fix
there was strong pressure in the markets
for the Swiss franc to appreciate
against the struggling euro and
eventually the Swiss central bank
decided to lift the cap on the Swiss
franc and as you can see what happened
pretty much immediately the Swiss franc
went up quite significantly against the
let's walk back a little bit since but
essentially it's gone up from point
eight three to about point nine two now
a fixed exchange rate is the opposite of
a floating exchange rate and in a fixed
system the currency is pegged for no
fluctuations in a fully fixed system
from the central agreed rate so in a
fixed system the central bank they'll
always operating on behalf of the
government operates a fixed or anchored
exchange rate the pegged rate becomes
the official rate at most of the time
people buying and selling currencies
trading investing will we'll happily
trade at the official rate well of
course in many countries there might
also be some unofficial trades I feel
like a shadow currency market where
people deal in in unofficial prices the
currency in a fixed system can change
but for that to happen the peg would
have to be altered so we call this if
you like the adjustable peg idea for
example a country might decide to
devalue the exchange rate or they might
decide to revalue so China in 2015
opted to try to devalue the you are
against the dollar and the Russian
government has also devalued on several
occasions recently a little bit example
of a fixed exchange rate is the Danish
kroner essentially fixed against the
euro de Denmark of course is inside the
European Union but it's outside the
single currency for many years they
fixed their currency against the German
deutsche mark now of course the deutsche
mark was gone for the moment and the
euro is the the currency in the upper
helium now some of you were thinking
what a minute Jeff that doesn't look
much like a fixed currency to me what
are you on about of course look up the
scale on the y-axis it looks like a
volatile currency but actually if I just
superimpose some numbers the Danish
currency against the euro has fluctuated
naught point six percent I've done the
math by the way against the Euro over
the last five years though it's
basically been fixed when the governor
of the Central Bank of dem watt wakes up
in the morning his first thought is
I need to keep the Danish kroner fixed
against the euro I need to intervene
maybe occasionally to help to make this
happen and when he goes to bed at night
he dreams of maintaining a fixed
exchange rate against the euro such as
the exciting time of the central bank
governor of Denmark now what about the
case for floating relative to the case
for fixing as I said this is a key
choice that governments need to make
some of these arguments get a little bit
complex but but bear with me they're
worth that worth thinking about
one like a country go for a floating
exchange rate the first point is that if
you have a floating exchange but you
don't really need much in the way of
foreign exchange reserves because you're
letting the currency find its own level
and a really crucial point if you go for
a floating exchange rate then that
allows you to set interest rates manage
your policy committee for example to
meet your domestic needs mid so for
example controlling inflation or
controlling the cycle so because you're
you're not having a target for the
exchange rate that allows interest rates
to be set for other macro objectives a
floating exchange rate could help to
prevent imported inflation so for
example it could be the case that
there's a rising the cost of imported
products but the exchange rate might
move in the opposite direction to help
absorb that case in point in 2014 by
Savoia was quite high we important one
of all oil but the pound was actually
appreciating against the US dollar so
made all a little cheaper at the time
for us I think a really key argument for
having a floating exchange rate is that
a floating currency provides a degree of
insulation for countries that are export
dependent but subject to vulnerable to
external shocks so take for example a
country that's exporting oil or gas and
the world price of those commodities
goes down your export sector is going to
take a hit and you may well suffer and a
worsening balance of payments position
well in that situation of floating
currency is likely to depreciate and
that should a help me to sell a bit more
oil and gas overseas but crucially it
should also increase the competitiveness
of your other industries
maybe car making or steel making or
farming for example commercial farming
might be able to sell some more output
so countries where there's a shock
basically a currency depreciation in a
floating system and that kind of
increases their potential for selling
exports from other industries those of
you who've seen our topic video on the J
curve and the Marshall Lerner condition
will know that a floating currency helps
to provide a partial so automatic
collection of the countries running a
big trade current account deficit if the
country is running a deficit exchange
that tends to fall and restore some
competitiveness floating currencies tend
to be less at risk or attack by
speculators and basically the
speculators are just you know interested
in attacking the weakest fixed exchange
rates and a fixed exchange rate might
actually conflict with other macro
objective perhaps you've set the fix
rate too high you end up with some
deflation you've set it to lower you end
up with a boom in the economy floating
exchange rate in theory should go with
the cycle go with the cycle of interest
rates and help to stabilize the economy
what about a fixed exchange rates in
some countries decide yes classically
we're going to go for a pegged or
anchored exchanger we want some
stability in our currency and I suppose
one of the key advantages of that is
that if people know what the currency is
going to be worth going forward that
creates confidence so the good people of
Denmark pretty much know what they the
Danish Krone is going to be against the
euro if you're looking to invest in
Denmark from other parts of the European
Union for example you have that
certainty about what the exchange rates
going to be that could well stimulate
some Winwood investment a lot of people
have to hedge against currency
volatility they have to buy their
currency weeks and months ahead of
course if you know what the exchange
rate is going to be there's less costs
of hedging and this is quite an
important point the third point on last
slide here if you have a strong fixed
exchange rate and you are fixing against
another low inflation country then
businesses know that they're pretty much
going to keep their costs
and their prices under control because
they can't rely on a depreciation to
make themselves more competitive a fixed
exchange rate which is credible and
stable leads to less risk in the markets
and actually that could lead to the
government having to offer lower
interest rates on their debt which can
be quite important and fixed exchange
rate also does place a lot of
responsibility on governments to get
their macro policies right because if
they allow the economy to grow too
quickly or inflation too is too fast and
a fixed exchange rate system jobs and
investment and income will be hit pretty
quickly last point is that if the fixed
exchange rate is credible if the market
is accepted that so there's often less
speculation because people just trade
that they at the prevailing exchange
rates but there's arguments for and
against both in the managed floating
system if you like is a little bit of a
hybrid so you try to get some of the
advantages of fixed exchange rates
through exchange rate manipulation some
of the advantages of allowing the
currency to float almost there on this
one one of the points we've mentioned is
they have a fixed exchange rate system
you you're pretty much going to need
some hefty reserves to intervene in the
currency markets Japan and China and
Switzerland other countries in the world
were the biggest foreign exchange
reserves
I mean China's case it's astronomically
big over 3.4 trillion dollars Japan over
1.2 trillion dollars so those countries
typically then they do intervene a lot
in their currency markets and they need
those those reserves of foreign
currencies to make an impact in the
market go back to the top of the table
Ireland and Greece of course a part of
the single currency so they don't have
to intervene in the currency markets
because the euro is a floating exchange
rate but even if Ireland was going it
alone for example and move back to the
punt with Greece move back to the
drachma it's not beyond the realms of
possibility of course then they'd have
to probably have significantly bigger
foreign exchange reserves than that
unless they were prepared to allow their
currencies to float fully
UK's currency reserves behind 155
billion dollars used to be a higher but
we solved most of our gold reserves so
some key arguments about fixed and
versus floating exchange rates a lot of
evidence with a little research and
there's no optimum exchange rate for any
one country it depends on the stage of
development it depends what the
objectives are fixed rates so fixed
exchange rates might be more optimal for
developing countries who really want to
get their inflation down so if they fix
their currency and it does put a
discipline on businesses to control
costs a lot of export-dependent
countries like Japan perhaps South Korea
they may affect China clearly they may
favor more of a managed floating system
because they want the exchange rate to
keep their export sectors competitive
one of struggling European countries of
course have been inside the Euro and
haven't had the luxury of an internal so
an external devaluation of that currency
and actually had to align internal
devaluation there's a general drift if
anything a little bit towards managed
floating a few countries now have a pure
free float but a game theory for those
of you understand the games that central
bank's play with with the speculators
not every country has the reserves to be
able to influence a currency or central
bank which is sufficiently powerful
China does the UK and Bank of England
could intervene but chooses not to we
often see increasingly countries looking
to deliberately reduce their exchange
rates that's called a competitive
devaluation with the appreciation and
that can happen when conventional policy
like interest rates have just haven't
worked last point really is that the
choice of currency regime is is really
really quite important for developing
countries there's a move I suppose
towards managed floating wealth and free
floating but it's a really key decision
for developing countries to to have
we've covered a lot in this video I
think then in the early stages of this
topic video is just the basics wasn't
about fixed and floating and we got into
so much more detail stuff near the end
so hopefully that was useful for you
that's a topic video on fixed and
floating exchange rates