To determine the most appropriate exchange-rate regime for a certain country is not a simple task as much will be at stake. The following figure shows the different regimes according to four different variables: exchange rate flexibility, loss of monetary policy independence, anti-inflation effect and credibility of the exchange rate commitment:. Dec 1.
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Lope Gallego. Summary Exchange rates can be understood as the price of one currency in terms of another currency. Your Cart 0. Fixed or Flexible Exchange Rates?
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The Determinants of the Choice between Fixed and Flexible Exchange-Rate Regimes
Bibliographic Information. History and Perspectives. This allowed for unrestricted capital mobility as well as global stability in currencies and trade. However, with the start of World War I, the gold standard was abandoned. At the end of World War II, the conference at Bretton Woods, an effort to generate global economic stability and increase global trade, established the basic rules and regulations governing international exchange.
As such, an international monetary system, embodied in the International Monetary Fund IMF , was established to promote foreign trade and to maintain the monetary stability of countries and, therefore, that of the global economy. It was agreed that currencies would once again be fixed, or pegged, but this time to the U.
Difference Between Fixed and Flexible Exchange Rates
This meant that the value of a currency was directly linked with the value of the U. So, if you needed to buy Japanese yen, the value of the yen would be expressed in U.
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If a country needed to readjust the value of its currency, it could approach the IMF to adjust the pegged value of its currency. The peg was maintained until when the U. From then on, major governments adopted a floating system, and all attempts to move back to a global peg were eventually abandoned in Since then, no major economies have gone back to a peg, and the use of gold as a peg has been completely abandoned.
The reasons to peg a currency are linked to stability. Especially in today's developing nations, a country may decide to peg its currency to create a stable atmosphere for foreign investment. With a peg, the investor will always know what his or her investment's value is and will not have to worry about daily fluctuations.
A pegged currency can help lower inflation rates and generate demand, which results from greater confidence in the stability of the currency.
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Fixed regimes, however, can often lead to severe financial crises, since a peg is difficult to maintain in the long run. This was seen in the Mexican , Asian , and Russian financial crises, where an attempt to maintain a high value of the local currency to the peg resulted in the currencies eventually becoming overvalued.
This meant that the governments could no longer meet the demands to convert the local currency into the foreign currency at the pegged rate. With speculation and panic, investors scrambled to get their money out and convert it into foreign currency before the local currency was devalued against the peg; foreign reserve supplies eventually became depleted.
In Mexico's case, the government was forced to devalue the peso by 30 percent. In Thailand, the government eventually had to allow the currency to float, and, by the end of , the Thai bhat had lost 50 percent of its value as the market's demand, and supply readjusted the value of the local currency.
Exchange rate regime
Countries with pegs are often associated with having unsophisticated capital markets and weak regulating institutions. The peg is there to help create stability in such an environment.
It takes a stronger system as well as a mature market to maintain a float. When a country is forced to devalue its currency, it is also required to proceed with some form of economic reform, like implementing greater transparency, in an effort to strengthen its financial institutions. Some governments may choose to have a "floating," or " crawling " peg, whereby the government reassesses the value of the peg periodically and then changes the peg rate accordingly.
Usually, this causes devaluation, but it is controlled to avoid market panic. This method is often used in the transition from a peg to a floating regime, and it allows the government to "save face" by not being forced to devalue in an uncontrollable crisis.