In a fixed
exchange rate system, the government (or the central bank acting on the government's
behalf) intervenes in the currency market so that the exchange rate stays close
to an exchange rate target. When Britain joined the European Exchange Rate
Mechanism in October 1990, we fixed sterling against other European currencies
Since autumn 1992, Britain has
adopted a floating exchange rate system. The Bank of England does not actively
intervene in the currency markets to achieve a desired exchange rate level. In
contrast, the twelve members of the Single Currency agreed to fully fix their currencies
against each other in January 1999. In January 2002, twelve exchange rates
become one when the Euro enters common circulation throughout the Euro Zone.
Exchange
Rates under Fixed and Floating Regimes
With floating exchange rates,
changes in market demand and market supply of a currency cause a change in
value. In the diagram below we see the effects of a rise in the demand for
sterling (perhaps caused by a rise in exports or an increase in the speculative
demand for sterling). This causes an appreciation in the value of the pound.
Changes in currency supply also have
an effect. In the diagram below there is an increase in currency supply (S1-S2)
which puts downward pressure on the market value of the exchange rate.
A currency can operate under one of
four main types of exchange rate system
FREE FLOATING
o
Value of the currency is determined solely by
market demand for and supply of the currency in the foreign exchange market.
o
Trade flows and capital flows are the main
factors affecting the exchange rate In the long run it is the macro economic
performance of the economy (including trends in competitiveness) that drives
the value of the currency. No pre-determined official target for the exchange
rate is set by the Government. The government and/or monetary authorities can
set interest rates for domestic economic purposes rather than to achieve a
given exchange rate target.
o
It is rare for pure free floating exchange rates
to exist - most governments at one time or another seek to "manage"
the value of their currency through changes in interest rates and other
controls.
o
UK sterling has floated on the foreign exchange
markets since the UK suspended membership of the ERM in September 1992
MANAGED FLOATING EXCHANGE RATES
o
Value of the pound determined by market demand
for and supply of the currency with no pre-determined target for the exchange
rate is set by the Government
o
Governments normally engage in managed floating
if not part of a fixed exchange rate system.
o
Policy pursued from 1973-90 and since the ERM
suspension from 1993-1998.
SEMI-FIXED EXCHANGE RATES
o
Exchange rate is given a specific target
o
Currency can move between permitted bands of
fluctuation
o
Exchange rate is dominant target of economic
policy-making (interest rates are set to meet the target)
o
Bank of England may have to intervene to
maintain the value of the currency within the set targets
o
Re-valuations possible but seen as last resort
o
October 1990 - September 1992 during period of
ERM membership
FULLY-FIXED EXCHANGE RATES
o
Commitment to a single fixed exchange rate
o
Achieves exchange rate stability but perhaps at
the expense of domestic economic stability
o
Bretton-Woods System 1944-1972 where currencies
were tied to the US dollar
o
Gold Standard in the inter-war years -
currencies linked with gold
o
Countries joining EMU in 1999 have fixed their
exchange rates until the year 2002
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