Floating and fixed exchange rates in global monetary policy

Financial and Monetary Economics

Since the end of World War II the issue of floating exchange rates in regards to currency has been increasingly brought to the forefront. Part of the reason for this is because the Breton Woods Agreement of 1944 established the dollar as the strongest currency in the world. Where, the greenback and other major currencies would be backed by the gold standard. Until.the1970's, this fixed rate currency system would serve as a way of providing the world with stable economic growth and low inflation. However, by the late 1950's and into the 1960's a shift would occur in this policy, where Europe and Japan were able to rebuild after the war, quickly become industrial power houses. (Breton Woods Agreement, 2010) Then, when you combine this with President Johnson's refusing to raise taxes to pay for spending on the Vietnam War and his Great Society programs, meant that the U.S. would begin to run a trade deficit. This was problematic because the gold standard was always used to support the dollar, with increased amount of capital outflow, meant that defending the dollar against speculative attacks would become less effective. As a result, the total amounts of gold that was backing the U.S. dollar would continue to decline. This is significant because it would underscore a shift that would occur in the way currencies trade with one another, where a new agreement would be created that would allow the major currencies of the world to float against one another (Breton Woods II). Since that time numerous countries around the globe have used either the fixed or floating exchanges rates as a part of their national monetary policy. (Roubini, 2008) Yet, the various economists will continue to debate as to the overall effectiveness of either system. To fully understand the benefits along with drawbacks of the fixed rate monetary system in relations to a floating rate system requires: providing a general overview of each system, why fixed exchange rate system are unstable, why the floating exchange rate systems are subject to volatility and looking at examples of the effects of both in the real world. Together, these different elements will provide the greatest insights as to what are the overall benefits and drawbacks of each type of monetary system.

Overview the Fixed Exchange Rate System

A fixed exchanged rate is where the central of bank of a given country will decide to peg their currency to some kind of precious metal such as: gold or to a currency / basket of currencies. This is because, as the country is developing the fixed exchange rate policy, it will allow the various imports and exports to remain more competitively price, especially if the peg is set low. Over the course of time, this will help the developing country to be able to increase the overall number of exports that they are selling in a particular country; because the various goods are cheaper. At which point, this would cause the developing country to begin to experience trade surpluses, which can be used to help increase the overall amounts of foreign investment capital. Once this takes place, it means that the government can begin spending the surplus and the foreign capital on developing infrastructure as well as modernizing their economy. The idea is that by engaging in such policies, a developing country can be able to quickly build their economy and the standard of living for the people. At which point, the fixed rate would more than likely be removed once the economy begins to mature. A good example of this can be seen in China, where they have been growing dramatically over the last 15 years. The problem is that they have kept the fixed exchange rate on their currency (the yuan) low against the dollar. In 2005, the U.S. along with other countries pressured them to loosen the peg and begin using fixed rates on other currencies. However, the global financial crisis has meant that Chinese imports into the United States have declined by 25.7% and there are a total of 23 million unemployed factory workers. As a result, China has once again lowered their peg against the dollar. (Wang, 2009) This is significant because it shows how the developed nations are trying to encourage China to abandon the fixed rate system. Yet, they are reluctant because engaging in such activities could have short to medium term impacts on their economy. To try and keep exports competitive, the central bank decided to lower the fixed rate relative to the dollar.

Overview of the Floating Rate Exchange System

In general, the floating rate exchange system is when the central bank of a particular country will allow their currency to float freely against the different currencies of the world. The idea is that such a system will promote the long-term stability of country's monetary policy; by allowing the forces of supply and demand to determine what would be the most appropriate exchange rate. During times of extreme pressure from the supply or demand side, the central bank is prepared to go in and support the currency, to help provide stability. This is significant because traders around the world; will use the major currencies as a way to hedge themselves against different risks. Where, they will view the weakness of one country's currency as a sign that they could be facing a number of different economic challenges. (Fixed vs. Floating Exchange Rate, 2007) a good example of this can be seen with the British pound, where the Bank of England decided to keep interest rates at .5%. This is important, because the increase in rates could be seen as a sign that economic stability could be returning to the country, which would help to reverse the downward pressure on the pound. However, the fact that they decided to keep interest rates unchanged, means that many traders / speculators will continue to place pressure on the currency. This is because of the perception that economy is not performing as well as the rest of the world. As a result, traders and speculators will sell the pound while buying another major currency such as the Japanese yen or U.S. dollar. (Bank of England's Decision Affects Pounds Performance, 2010)

Benefits vs. Drawbacks of the Floating Exchange Rate Policy

There are a number of different benefits and drawbacks that the floating exchange rate system offers. The most notable benefits would include: it allows the government to have greater control over the economy. The drawbacks of the floating rate system would include: it allows the country's currency to be subject to extreme amounts of fear and greed. (Fixed vs. Floating Exchange Rate, 2007) When looking at the benefit of the floating rate system, it allows the government to have greater control of the economy, it is clear that such a system can be used to effectively maintain the balance between the forces of supply and demand, within the currency markets. This is because the lack of intervention from the government, allows the free market to function most effectively. Over the course of time, this policy will allow the economy to be protected from outside shocks that could occur (such as a sharp rise in commodities prices). This allows the central bank to have greater control when setting interest rate policy, as they can respond naturally to what the forces of supply and demand are dictating. Once this occurs, the government has greater control of the economic agenda, where they can set policies (i.e. taxation) that can address any kind of trade surpluses or trade deficits in real time. At which point, the long-term stability of the economy is more balanced, because the government is able to effectively control these two issues. A good example of this can be seen in Japan, where they were able to effectively manage their currency to create a trade surplus. While, at the same time encouraging consumers to begin saving. This is significant because since Japan switched to such a policy, they have greater control over the economy. As the country, was able to continue to see high amounts of savings rates and trade surpluses, which are used to invest in other areas around the world. (12 Myths of International Trade, 1999)

The biggest drawback of the floating exchange rate policy is: it allows the country's currency to be subject to extreme amounts of fear and greed. This is because the currency markets are constantly facing large amounts of emotionalism. Where, the slightest piece of news can cause: investors, traders and speculators to believe the best or worst case scenario is occurring. When the currency is floating up or down, they will often look at other outside information to have an indication as to if the overall up or down trend will remain in place. At certain times, these amounts can become so extreme, that the central bank is forced to reduce the overall money supply in an attempt to address this issue. This would normally occur, when the currency has remained strong for large amounts of time. An example of when the central bank would be reducing the available supply of money can be seen in the U.S. dollar from 1995 to 2000. During this time, the demand for dollar based assets would rise dramatically, as the investors, traders and speculators wanted to own American based assets at any cost. This was a reflection of the above average growth that the economy was experiencing at the time. The problem began with the belief that economic growth was going to continue for some time, developing a bubble in dollar based assets. To deflate this bubble, the Federal Reserve would raise interest rates and would restrict the amount of money that was released to the financial system. This would cause the dollar to begin an inevitable decline that would become more severe within the next several years. (Rise of the Dollar, 2005)

There can also be other situations where speculators will attempt to drive the price of the currency down as much as possible. An example as to when speculators and traders can irrationally affect prices on the downside would be with the British pound during the early 1990's. Where, George Soros would begin aggressively shorting / selling the pound in 1992. This was because the currency had appreciated dramatically throughout the 1980's. At which point, the forces of supply and demand would become unbalanced. (Egndahl, 1996) as a result, speculators like Soros would smell blood in the water and begin selling the currency aggressively. Over the course to time, Soros would make $1 billion off of the transaction. What the two examples highlight is the biggest weaknesses that are associated with the floating rate currency system. Where, extreme amounts of fear or greed can exacerbate the up and down moves. Once either situation takes place, it means that the central bank will have to take extreme actions to increase / reduce the overall money supply on the markets.

Clearly, the fixed and floating rate exchange systems have a number of different strengths as well as weakness. As far as fixed a rate policy is concerned, the most notable benefits as well as drawbacks would include: it reduces the risks of trading / investing in a particular country and it can create deflationary bubbles. While, the different benefits as well as drawbacks of the floating rate system would include: it allows the government to have greater control over the economy and it allows the country's currency to be subject to extreme amounts of fear / greed. These are important because they underscore how some kind of balance must be applied as to how the central bank will use the different monetary tools. The reason why, is they are engaging in such actions that will support a particular policy for to long. This will cause the forces of supply and demand to become pent up or out of control. Once, this take place, it means that the currency will go through wild fluctuations, as it will attempt to balance out the forces of supply and demand. An example of such a situation for the fixed rate policy would be with Argentina during the late 1990's and early 2000's. As the appreciation in the dollar, would cause the country to face a crisis because of this policy. An example of a situation with the floating rate policy can be seen with the United States in 2000. Where, the overall amounts of greed run amok would force the Federal Reserve to limit the amount of currency available in the markets. As they were attempting, to address this obvious imbalance that were occurring. Together, these different elements highlight the overall challenges that are faced by both polices, where they can provide a number of different benefits. However, if one policy is embraced for to long it will cause imbalances to occur. This is why the central banks around the world should have flexibility when using the different tools of monetary policies.