The Influence Of The Different Exchange Rate

Published Date: 02 Nov 2017

regimes on a macroeconomic level.

Student name: Martijn Boesser

Student number: 2519782

Contact e-mail: [email protected]

Thesis supervisor: Xiaoyu Shen

Faculty: FEWEB, Pre-master Business Administration (Financial management)

Summary

Introduction

Exchange rates have always been a point of discussion. Almost everyone in the world has been confronted with exchange rates. Whether this is on a holiday while taking money from the ATM, news about the euro losing value or declining imports from a country, because of rising exchange rates. Over the last decade exchange rates played an important role in the world economy. The different exchange rate regimes any given country chooses can have several advantages and/or disadvantages. Especially during the crises from the beginning of 2008 until now the exchange rates of the euro are daily news. Many countries of the Eurozone are in financial distress and need to be funded by public money to avoid bankruptcy. All of these problems cause the euro to decline in value rapidly in contrary to other currencies. The choice of exchange rate regime show the plan or position of a country towards other countries in the world. A chosen regime can for example; boost the production export to other countries or make it possible to import products from other countries for less money.

The research question for this thesis is: What is the impact of the different types of exchange rate regimes on a macroeconomic level? First it is important to know how the exchange rate system originated from a historical perspective and what types of exchange rates regimes countries are using. After these two questions are answered we investigate the choice of a given exchange rate regime and which exchange rate suits a particular country the best? At the end of the thesis the last question comes to order. What is the impact of these different types of exchange rate regimes?

History of exchange rates regimes

In this chapter we will discuss the different time periods in which the exchange rate evolved to the exchange rate system(s) we are using now. In a time period of over a hundred years there has been a lot of changes in the way we use the exchange rate system currently.

From the beginning of the 19th century until the beginning of the 20th century almost all of the currencies were redeemable into gold. In that way you could use your own currency and trade it into a specified amount of gold. In this time period gold stayed at a fairly stable price. [1] Britain was one of the first countries to introduce the system to exchange pounds for gold in 1821. Most of the countries followed Britain shortly after. The result was an economy were gold was the primary commodity for exchanging money and the British pound sterling was the most important currency in this system, because they were the most powerful country and the first to adopt the system at that time.

At the beginning of the First World War in 1914 until 1925 the checks that insured fiscal restraint during the classical gold standard era were deemed unacceptably restrictive during the war. Because of the restrictions during the world war most of the country’s abandoned the system were people could exchange their currency for gold. The United States was one of the few countries that still used the gold standard until 1917. The late exit of the united states of the use of the gold standard played a significant role with the dollar as the world’s "reserve currency". Now the gold standard system was cut, governments intervened in the market to keep their currency rates at a certain level. They called the intervenience of the government a "dirty float" system.

After World War I between 1926 and 1931 most of the countries went back to the old gold standard system, but at the Genoa conference of 1922 they had a plan to initiate a new system. Dollars can still be exchanged into gold, but all the others currencies would have to use a "gold-bullion standard". They can still redeem their money into gold at the old rates, but only at large bar-sized weights. Moreover, the big European currencies would be simultaneously redeemable into pounds and pounds into dollars. Europe was strongly against the system were they had to maintain the prior redemption rates. Britain had to abandon the gold-exchange standard, because of the global recession of 1929 the unemployment rates went up to about 20%. Because of all these problems there were worries that one of the banks was going insolvent. The result was that most of the foreigners who had money on British banks began to redeem their British pounds for gold. This caused a problem in the gold reserves of the country and they faced with the option of going off the gold standard or raising the interest rates. They had chosen to go off the gold market, because raising the interest rates would only cause the employment rate to increase even more. [2] 

From 1932 until 1944 the Europeans governments returned on their monetary promises in order to soothe the people. The result was a system of floating exchange rates and dollar the only significant link to the gold standard. The link to the gold standard lost strength because of the great depression the United States was facing. The Roosevelt administration suspend the conversion into gold locally, devalued the dollar from 20 dollar an ounce to 35 dollar an ounce and required that locally held specie be turned in the Federal Reserve. Although there were a lot of measures taken, the dollar became the world’s "hardest currency", because foreign holders of the dollar were still able to convert their dollars into gold.

By 1944 most of the governments had the opinion that the dirt float system was not an optimal system. In 1944 the United Nations met at Bretton Woods to come up with a new system. The Bretton woods system created a system were countries could trade one currency for another. Because the United States had almost half of the world’s manufacturing capacity in hands and most of the worlds gold, the leaders decided to peg the currencies to the US dollar. The dollar would then be still convertible into gold for a price of 35 dollar per ounce. Under this new system, central banks of other countries than the United States had the task to maintain their currencies and the dollar at a fixed exchange rate. Fixing an exchange rate was possible by selling its own currency for dollars and buying a countries own currency. This system would last until the year 1972 [3] 

During the 1960s the United States began to spend largely in domestic goods and also spend a lot of their money abroad to fight the Vietnam War. In result foreign governments had a relatively large amount of dollars available in the early 1970s. By this time only around 20% of the dollars were backed by gold and the US government was not able to pay out all of the dollars in gold. The US chose to suspend the possibility the convert dollars into Gold. They called this "The Nixon Shock". The Smithsonian Agreement was shortly introduced hereafter. The dollar was devalued to about 38 dollar an ounce and foreign currencies would remain pegged to the dollar. The Smithsonian Agreement lasted only for about a year. At that time the major economic powers of Europe decided to use a floating currency rate once more.

The Smithsonian Agreement persisted only about a year, because the dollar declined heavily in value against gold after the Nixon Shock. From 1974 until 1979 the economically bigger countries hereby abandoned their stated pegs against the dollar and floated their currencies. They did try however to reintroduce the fixed exchange rate regimes in Europe, but it lacked foundation. However there were some developing countries that kept their pegged currencies to the dollar.

A new system in Europe was introduced in the late 1970s: the Exchange Rate Mechanism, in short ERM. Within this system countries agreed on using the central banks to intervene in the market to keep their currencies within a range of 2,25% of one another participating country (semi-pegged system). The UK entered the ERM system in 1990, but had to exit the system after two years, because the pond sterling came under increasing pressure from currency speculators. In august 1993 they expanded the margin percentage tot 15% to suppress rising speculations against the French franc and other currencies. With the introduction of the euro in 1999 the ERM II replaced the original ERM. Today most of the big economic powers such as the dollar, euro and pound use a free float regime, wherein a currency’s value is allowed to fluctuate according to the foreign exchange market or use a managed float regime. [4] 

In conclusion from the beginning of the early 1900’s until now, gold and the US dollars played a significant part in the history of the exchange rate regimes. The possibility to change different amount of dollars for a specified amount of gold initiated the development of the exchange rate regimes. Over time the gold system became impossible to use, because of the relatively low available gold supply and increasing economic uncertainties. The US had to cut their ties between the dollar and gold because of these uncertainties. Today most of the big economic powers use a free-floating system.

Types of exchange rate regimes we are using today

Nowadays there are many different types of exchange rates since the gold standard is abandoned. A currency can either be fixed are floating, but there are many other subcategories within these two regimes. In this chapter we will go into the different types of exchange rates, the pros and cons of each type and for which countries these types are desirable. The choice of exchange-rate regime influences the way in which economic disorders affect an economy. [5] 

Floating exchange rates

The most common and used exchange rate we are using today is the (independently) floating exchange rate. The exchange rate is market-determined, wherein a currency's value is allowed to fluctuate according to the foreign exchange market. The Yen, euro and the dollar for example have a floating exchange rate. The floating exchange rate is determined by the demand and supply of a market. A floating exchange rate is constantly changing, because the supply and demand of a country is not always the same. For example if the demand for a currency is low, the currency will decrease in value. In return this makes importing goods more expensive, because a countries own currency is decreasing in value and the exchange for foreign currency is getting more expensive.

Some of the pros and cons of a floating currency are interchangeable. If a countries exchange rate is low, there will be more demand for the export of goods and if the exchange rate is high it will be relatively less expensive to import goods in a foreign currency. Free floating regimes also decrease the impact of economic shocks and decrease the effect of foreign business cycles. Although there are many pros for choosing an floating exchange rate, the biggest con of using a free-floating system is the unpredictability of the system as a result of their great dynamic.

The floating regimes can be divided in managed floating systems and dirty floating systems. In the previous chapter dirty floating systems were already used in the early 1900’s. With managed floating systems the government intervenes in the market to influence the exchange rate of the country. The monetary authority attempts to influence the exchange rate without having a specific exchange rate path or target. Indicators for managing the rate are broadly judgmental (e.g., balance of payments position, international reserves, parallel market developments), and adjustments may not be automatic. Intervention may be direct or indirect. [6] 

Fixed/pegged exchange rates

Fixed exchange rates can be divided in hard pegs and soft pegs. With hard pegged exchange rates, the government determines a fixed exchange rate and exactly maintains the rate at that level.  This can be the use of another country’s currency (also known as full dollarization or an exchange arrangement with no separate legal tender) or a set price will be determined against a major world currency (also known as a currency board). This can either be the euro, yen, dollar or any other combination, but most of the countries set their currency against the US dollar. It can even be pegged against gold, which we showed in the previous chapter. To maintain their own exchange rate, the central bank has to buy or sell its own currency on the foreign exchange rate market in return for the currency they fixed against. For example if the value of a single local currency resembles 3 United States dollar, the central bank has to maintain the local currency at this level. In order to keep the exchange rate at this level the bank must keep a high level of the foreign currency they pegged against. The bank can either release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation) and ultimately, the exchange rate. The central bank can also adjust the official exchange rate when necessary. [7] 

Unlike hard pegs, soft pegs are allowed to fluctuate more between the two currencies. The fluctuation percentage between these currencies lies between a percentage of -1 to 1 or up to a -30 and 30 percent range of the pegged currency. These fluctuation rates depend on the differences in inflation rates of countries. Costa Rica, Hungary, and China are examples of this type of peg. Although soft pegs maintain a firm "nominal anchor" (that is, a nominal price or quantity that serves as a target for monetary policy) to settle inflation expectations, they allow for a limited degree of monetary policy flexibility to deal with shocks. However, soft pegs can be vulnerable to financial crises, which can lead to a large devaluation or even abandonment of the peg and this type of regime tends not to be long lasting. For example crawling pegs, where the currency is adjusted periodically in small amounts at a fixed rate or in response to changes in selective quantitative indicators, such as past inflation differentials. [8] 

Countries mainly have the preference for a fixed exchange rate regime for the aim of export and trade. By controlling their currency, a country can keep its exchange low to sustain a high export level. The real advantage of the fixed exchange rate is seen in trade relationships between countries with relatively low costs of production and countries with strong currencies. They keep their exchange rate low, so the costs of manufacturing and exporting goods for the stronger economic powers are relatively "cheap" in these countries.

Cons for a fixed exchange rate are that it requires large amounts of foreign reserves as the central bank of the country is constantly buying and selling the foreign currency. Having large amounts of foreign currency causes the inflation to rise, so the more currency reserves, the wider the monetary policy, causing prices to rise. This is particularly destructible for countries that want to keep their prices stable. [9] 

Floating and fixed exchange rates both have several advantages and disadvantages. Most of the bigger economic powers have an independently floating exchange rate regime and the smaller or developing countries mostly choose to have a fixed exchange rate to keep the export level of products to the more developed countries high. Appendix 6.1 shows all the countries of the world and their exchange rate regimes.

Choice of an exchange rate regime

In this chapter we will discuss why countries choose to have a particular exchange rate regime.

There are many different suggestions why some countries choose a floating regime or a fixed regime. As seen in appendix 6.1, almost all the emerging countries choose to have an independently floating exchange rate and most of the developing countries choose to have a fixed exchange rate.

The choice of an exchange-rate regime can influence the way in which economic disturbances affect the open economy. This mainly depends on the overall importance of these economic disturbances to a specific economy or country. The performance and regime choice of an economy is shaped by the economy’s institutional and financial maturity and its openness to capital flows. There are many different factors that influence these three points, like: the size of the economy, export structure, the degree of labour and capital mobility, the vulnerability to real/nominal shocks etc. Over the past years increased capital mobility has played the most important role of choosing an exchange rate regime in emerging economies. Capital mobility is the ability of private funds to move in and out of a country.

Most of the literature about the choice of an exchange rate regime can be divided in three categories:

• the adjustment, policy effectiveness and insulating properties of the regime;

• using an exchange rate peg as an alternative nominal anchor; and

• adopting pegged exchange rates (or a common currency) to foster deeper goods and capital market integration