In the modern world, most of the world's currencies are floating, and include the most widely traded currencies: the United States dollar
, the euro
, the Swiss franc
, the Indian rupee
, the pound sterling
, the Japanese yen
, and the Australian dollar
. However, even with floating currencies, central banks
often participate in markets to attempt to influence the value of floating exchange rates. The Canadian dollar
most closely resembles a pure floating currency because the Canadian national bank
has not interfered with its price since it officially stopped doing so during 1998. The US dollar is a close second, with very little change of its foreign reserves
. By contrast, Japan and the UK intervene to a greater extent, and India has medium-range intervention by its national bank, the Reserve Bank of India
From 1946 to the early 1970s, the Bretton Woods system
made fixed currencies the norm; however, during 1971, the US government decided to discontinue maintaining the dollar exchange at 1/35 of an ounce of gold and so its currency was no longer fixed. After the end of the Smithsonian Agreement
in 1973, most of the world's currencies followed suit. However, some countries, such as most of the Arab states of the Persian Gulf
region, fixed their currency to the value of another currency, which has been associated more recently with slower rates of growth. When a currency floats, quantities other than the exchange rate itself are used to administer monetary policy
(see open-market operations
Some economists believe that in most circumstances, floating exchange rates are preferable to fixed exchange rates
. As floating exchange rates adjust automatically, they enable a country to dampen the effect of shocks
and foreign business cycles
and to preempt the possibility of having a balance of payments crisis
. However, they also engender unpredictability as the result of their variability, which can render businesses' planning risky since the future exchange rates during their planning periods are uncertain.
However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. That may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency "strong" or "high" relative to others, such as the UK, or the Southeast Asia countries before the 1997 Asian financial crisis
The debate of choosing between fixed and floating exchange rate methods is formalized by the Mundell–Fleming model
, which argues that an economy (or the government) cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It must choose any two for control and leave the other to market forces.
The primary argument for a floating exchange rate is that it allows monetary policies to be useful for other purposes. Using fixed rates, monetary policy is committed to the single goal of maintaining the exchange rate at its announced level. However, the exchange rate is only one of the many macroeconomic variables that monetary policy can influence. A system of floating exchange rates leaves monetary policymakers free to pursue other goals, such as stabilizing employment or prices.
During an extreme appreciation
of currency, a central bank
will normally intervene to stabilize the currency. Thus, the exchange rate methods of floating currencies may more technically be known as managed float
. A national bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by a national bank may take the form of buying or selling large lots in order to provide price support or resistance or, in the case of some national currencies, there may be legal penalties for trading outside these bounds.
Aversion to floating
A free floating exchange rate increases foreign exchange volatility. Some economists believe that this could cause serious problems, especially in developing economies. Those economies have a financial sector with one or more of following conditions:
- high liability dollarization
- financial fragility
- strong balance sheet effects
are denominated in foreign currencies while assets are in the local currency, unexpected depreciations of the exchange rate deteriorate bank and corporate balance sheets and threaten the stability of the domestic financial system.
Therefore, developing countries seem to have greater aversion to floating, as they have much smaller variations of the nominal exchange rate but experience greater shocks and interest rate and reserve changes.
This is the consequence of frequent free floating countries' reaction to exchange rate changes with monetary policy
and/or intervention in the foreign exchange market
The number of countries that show aversion to floating increased significantly during the 1990s.
- ^ Calvo, G.; Reinhart, C. (2002). "Fear of Floating". Quarterly Journal of Economics. 117 (2): 379–408. doi:10.1162/003355302753650274.
- ^ Levy-Yeyati, E.; Sturzenegger, F. (2005). "Classifying Exchange Rate Regimes: Deeds vs. Words". European Economic Review. 49 (6): 1603–1635. doi:10.1016/j.euroecorev.2004.01.001. hdl:10915/33939.
Last edited on 18 March 2021, at 22:33
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