Question

6. 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

It is impossible to draw a distinct line between managed and fixed exchange rates.

A managed exchange rate is more like one of the options to make the exchange rate fixed.

If a currency is traded on the open market but the government/central bank wants to maintain a more or less stable price against another currency or a basket of currencies they do so by trading large volumes of their own currency with the goal to move the price back into the range they want to maintain - if they’re buying their own currency (getting it higher), they’re selling their reserve of foreign currency (or vice versa in case of selling their own one to get it lower). In short: they’re creating supply or demand on the market to move it in their favour - they’re managing their exchange rate.

Another way would be to make it illegal to trade a currency at a different price - which ultimately could also be described as taking it off the open market. The problem is that it is very likely leading to black markets instead.

When we’re talking about a managed exchange rate it is important to understand that we’re not necessarily talking about a rate that is fixed on both sides (upper- and lower-limit like a band). The swiss national bank maintained a ceiling against the EUR for a few years until January 2015 but no floor. The SNB sold swiss franc (CHF) and bought the EUR when the exchange rate climbed higher than 1.20 (they diversified their EUR reserves later). The SNB did that to keep their economy competitive during a time the EUR was very cheap and too much money was seeking the safe haven of Switzerland.

Managed rate foreign exchange rates have these main advantages:

• No need for international management of exchange rates: Unlike fixed exchange rates based on a metallic standard, floating exchange rates don’t require an international manager such as the International Monetary Fund to look over current account imbalances. Under the floating system, if a country has large current account deficits, its currency depreciates.

• No need for frequent central bank intervention: Central banks frequently must intervene in foreign exchange markets under the fixed exchange rate regime to protect the gold parity, but such is not the case under the floating regime. Here there’s no parity to uphold.

• No need for elaborate capital flow restrictions: It is difficult to keep the parity intact in a fixed exchange rate regime while portfolio flows are moving in and out of the country. In a floating exchange rate regime, the macroeconomic fundamentals of countries affect the exchange rate in international markets, which, in turn, affect portfolio flows between countries. Therefore, floating exchange rate regimes enhance market efficiency.

• Greater insulation from other countries’ economic problems: Under a fixed exchange rate regime, countries export their macroeconomic problems to other countries. Suppose that the inflation rate in the U.S. is rising relative to that of the Euro-zone.

Managed rate foreign exchange rates have these main disadvantages :

• Higher volatility: Floating exchange rates are highly volatile. Additionally, macroeconomic fundamentals can’t explain especially short-run volatility in floating exchange rates.

• Use of scarce resources to predict exchange rates: Higher volatility in exchange rates increases the exchange rate risk that financial market participants face. Therefore, they allocate substantial resources to predict the changes in the exchange rate, in an effort to manage their exposure to exchange rate risk.

• Tendency to worsen existing problems: Floating exchange rates may aggravate existing problems in the economy. If the country is already experiencing economic problems such as higher inflation or unemployment, floating exchange rates may make the situation worse.

Advantages of fixed exchange rates :

1. Avoid currency fluctuations. If the value of currencies fluctuates, significantly this can cause problems for firms engaged in trade.

• For example, if a firm is exporting, a rapid appreciation in Sterling would make its exports uncompetitive and therefore may go out of business.
• If a firm relies on imported raw materials, a devaluation would increase the costs of imports and would reduce profitability.

2. Stability encourages investment. The uncertainty of exchange rate fluctuations can reduce the incentive for firms to invest in export capacity. Some Japanese firms have said that the UK’s reluctance to join the Euro and provide a stable exchange rate makes the UK a less desirable place to invest. A fixed exchange rate provides greater certainty and encourages firms to invest.

3. Keep inflation low. Governments who allow their exchange rate to devalue may cause inflationary pressures to occur. Devaluation of a currency can cause inflation because AD increases, import prices increase and firms have less incentive to cut costs.

Disadvantages of fixed exchange rates :

1. Conflict with other macroeconomic objectives : To maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives.

• If a currency is under pressure and falling – the most effective way to increase the value of a currency is to raise interest rates. This will increase hot money flows and also reduce inflationary pressures. However higher interest rates will cause lower aggregate demand (AD) and lower economic growth, If the economy is growing slowly this may cause a recession and rising unemployment.

2. Less flexibility : In a fixed exchange rate, it is difficult to respond to temporary shocks. For example, if the price of oil increases, a country which is a net oil importer will see a deterioration in the current account balance of payments. But in a fixed exchange rate, there is no ability to devalue and reduce current account deficit.

3. Join at the wrong rate : It is difficult to know the right rate to join at. If the rate is too high, it will make exports uncompetitive. If it is too low, it could cause inflation. In the late 1980s, the UK chancellor, Nigel Lawson tried to shadow the DM and keep Sterling low; this led to a rise in inflation. In 1990, the UK joined the ERM, but the rate proved too high and trying to keep the value of the Pound high led to high-interest rates and the recession of 1991/92.