Critical Comparison of Fixed and Floating Exchange Rate Mechanisms
Introduction
This paper will examine independently floating exchange rate arrangements and other conventional fixed peg arrangements in separate sections. Each section contains four parts:
• An examination of the mechanics of the regime;
• A discussion of its advantages and disadvantages;
• An analysis of the experiences of selected nations and how these experiences highlight the strengths and weakness of the system; and
• My final thoughts on that particular exchange rate regime.
1. Conventional fixed peg arrangements
a. Mechanics of conventional fixed peg arrangements
Fixed peg arrangements are recognized by the IMF as a fairly inflexible exchange rate regime. Countries in this category peg their currency, either formally or on a se facto basis, to another currency or a basket of currencies at a fixed rate. Such a basket would contain the currencies of major trading or financial partners which are weighted to reflect distribution of sales, services and cash flows.
The exchange rate is allowed to fluctuate within limits one percent above and below the fixed central rate. It is the role of the nation’s monetary authority to maintain the fixed parity using either direct or indirect intervention. Direct intervention involves buying and selling the currency in the foreign exchange market, whereas indirect intervention involves the aggressive use of interest rate policy, foreign trade regulation or the intervention by other public institutions.
b. Advantages and disadvantages of fixed peg arrangement
It is argued that fixed rates provide certainty for international businesses by eliminating foreign exchange risk which will encourage foreign investment and that fixed rates should eliminate destabilizing speculation. This is often seen as the most compelling endorsement of fixed rate regimes. However this argument is fallacious if the level of the peg is unsustainable.
An unsustainable peg will lead to currency reserves being run down causing a currency
This paper will examine independently floating exchange rate arrangements and other conventional fixed peg arrangements in separate sections. Each section contains four parts:
• An examination of the mechanics of the regime;
• A discussion of its advantages and disadvantages;
• An analysis of the experiences of selected nations and how these experiences highlight the strengths and weakness of the system; and
• My final thoughts on that particular exchange rate regime.
1. Conventional fixed peg arrangements
a. Mechanics of conventional fixed peg arrangements
Fixed peg arrangements are recognized by the IMF as a fairly inflexible exchange rate regime. Countries in this category peg their currency, either formally or on a se facto basis, to another currency or a basket of currencies at a fixed rate. Such a basket would contain the currencies of major trading or financial partners which are weighted to reflect distribution of sales, services and cash flows.
The exchange rate is allowed to fluctuate within limits one percent above and below the fixed central rate. It is the role of the nation’s monetary authority to maintain the fixed parity using either direct or indirect intervention. Direct intervention involves buying and selling the currency in the foreign exchange market, whereas indirect intervention involves the aggressive use of interest rate policy, foreign trade regulation or the intervention by other public institutions.
b. Advantages and disadvantages of fixed peg arrangement
It is argued that fixed rates provide certainty for international businesses by eliminating foreign exchange risk which will encourage foreign investment and that fixed rates should eliminate destabilizing speculation. This is often seen as the most compelling endorsement of fixed rate regimes. However this argument is fallacious if the level of the peg is unsustainable.
An unsustainable peg will lead to currency reserves being run down causing a currency
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