Question

Explain the difference between a fixed rate and a managed rate foreign exchange rate regime and their advantages and disadvantages. Using an example explain how governments under a managed floating rate regime intervene to get their FX rate in line using a sterilized intervention

Answer 1

A fixed rate foreign exchange rate regime is a rate the government sets and maintains as the official exchange rate.This set price is determined against the major world's currency.

Advantages of a fixed rate foreign exchange rate regime - This regime leads to stability of exchange rates which helps avoid shocks to the exchange rate system assuring stability to both importers and exporters. Also, speculation cannot be done and this regime puts a constraint on irrational government policies as they may impact the forex reserves.

Disadvantages of a fixed rate foreign exchange rate regime - Pegging to a fixed rate regime is not an easy task as central banks constantly needs to monitor the markets. This is because this may cause conflicts with the policy as this regime may not be compatible with other macro-economic targets.

Managed rate foreign exchange rate regime - Such rate regimes do not go either for fixed rate or floating rate regime, but embrace a managed float or a mixed approach to the exchange rate. In such exchange rate regime, the exchange rate move up and down freely according to the laws of supply and demand. However, when there are wild exchange rate movement, the central banks step in, to curb the extreme movement by buying or selling reserves in open market.

Advantages of a fixed rate foreign Managed rate regime - Such regime advantage is that they adjust themselves automatically, in most of the times when the central bank does not step in. The biggest advantage is that on one hand the exchange rate is determined by market forces thus reducing any external shock, at the same time, any highly adverse fluctuations can be curbed by the central bank to a certain extent.

Disadvantages of a fixed rate foreign Managed rate regime - The biggest disadvatage is that this regime leads to instability as market forces can lead to frequent fluctuations in exchange rate leading to uncertainty for exporters and importers. Also, the central bank has to constantly monitor the rate and has to shore up enough reserves for time when its intervention is needed.

The central banks intervene to get their FX rate in line.They do so by buying and selling domestic currency. If the central bank sells domestic currency, in exchage of foreign currency, this transaction will raise the supply of domestic currency causing a reduction in the value of the domestic currency and thus the domestic currency depreciates. Conversely, if the central bank needs to raise the value of the domestic currency, it will instead sell the domestic currency in exchange of the foreign currency, leading to the domestic currency appreciation.