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Study notes

Exchange Rates - Currency Systems

  • Levels: A Level, IB
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

The choice of exchange rate regime is one of the most important that a country can make as part of monetary policy

Fixed and floating exchange rates - revision video
  • A free-floating currency where the external value of a currency depends wholly on market forces of supply and demand
  • A managed-floating currency when the central bank may choose to intervene in the foreign exchange markets to affect the value of a currency to meet specific macroeconomic objectives
  • A fixed exchange rate system e.g. a currency peg either as part of a currency board system or membership of the ERM II for countries intending to join the Euro.
Euro (EUR) to British pound (GBP) monthly exchange rate from November 2014 to November 2018

Free Floating Exchange Rate

  • The value of a currency is determined purely by demand and supply of the currency
  • Trade flows and capital flows affect the exchange rate under a floating system
  • There is no target for the exchange rate and no intervention in the market by the central bankSterling has floated since the UK suspended membership of the ERM in September 1992
  • The Bank of England has not intervened to influence the pound’s value since it became independent in 1997

Managed Floating Exchange Rate

  • Value of the currency is determined by market demand for and supply of the currency
  • Some currency market intervention might be considered as part of demand management (e.g. a desire for a lower currency to boost exports)Governments normally engage in managed floating if not part of a fixed exchange rate system. Managed floating was a policy pursued in the UK from 1973-1990

Semi-Fixed Exchange Rates

  • Exchange rate is given a specific target. The currency can move between permitted bands of fluctuation on a day-to-day basis
  • Interest rates are set at a level necessary to keep the exchange rate within target range – or direct intervention in the FOREX market

Fully-Fixed Exchange Rates

  • The exchange rate is pegged and there are no fluctuations from the central rate
  • A country can automatically improve its competitiveness by reducing its costs below that of other countries – knowing that the exchange rate will remain stable
  • Several countries operate with fixed exchange rates or currency pegs. The Ivory Coast Franc is pegged to the Euro, with the French Treasury guaranteeing convertibility. This facilitates exchange rate and price stability. The peg is not threatening international competitiveness given the low inflation rate in the Ivory Coast.

Summary of the arguments for floating and fixed exchange rate systems

Test Your Knowledge MCQ on Fixed and Floating Exchange Rates - revision videos

MCQ Revision Question: Floating Exchange Rates - revision video
MCQ Revision Question: Fixed versus Floating Currencies - revision video

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