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Advantages/ Disadvantages of Fixed Rate System

Advantages/ Disadvantages of Fixed Rate System

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Free Floating Exchange Rate System
• Exchange rate is determined by market forces with out

the direct intervention of the government
• Allows complete flexibility
• Advantage
• Insulates one country from the inflation of another country
• Insulates the unemployment problems in other countries
• Central bank is not required to constantly monitor and intervene in

the exchange rate process
• Allows government to implement polies without the concern of
central bank intervention
• If exchange rates did not float – investor would invest monies in the
countries with the highest returns – causing the government with
low interest rates to restrict the out flow of capital.
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Free Floating Exchange Rate System
• Disadvantages
• Can be a disadvantage for a country that initially experiences
economic problems
• Free floating exchange rate can adversely effect a country with
high unemployment rate.

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Managed Float Exchange Rate System
• Many exchange rate system that exist today lie

somewhere between a fixed and a freely floating system
• Critics say that this allows a government to manipulate
the exchange rate to benefit its own country.
• A government may weaken its currency to stimulant a stagnant

economy
• This argument is of course valid for fixed exchange rate

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Pegged Exchange Rate System
• They peg their currency to another currency or an index of

other currencies
• Usually they peg to a stable currency like the dollar.
• Tend to make the currency stable.
• Tends to attract foreign investment
Limitations
• weak economic or political conditions can cause investors
to be concerned the peg will hold
• The fear of the peg being broken will cause investors to
quickly sell their investments
• If investors sell quickly it places a downward pressure on
the local currency
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European Monetary System (1979)
• Initially pegged all currencies to a European Currency

Unit (ECU)
• All to fluxuate 2.25%
• This forced countries to have somewhat similar interest
rates
• When some countries broke from this system in order to
reduce interest rated and stimulate their economy – it was
concluded that only a permanent system would work and
the EURO was created. (1999)

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Other Pegged Systems
• Mexico (1994)
• Pegged to the dollar – caused the value of the Peso to rise and
caused a balance trade problem with increased import purchases.
• Central bank intervention - devalued the peso by 13% percent
• Caused a mass sell of peso as fear of further devaluation arose –
cause additional downward pressure on the peso
• Resulted on a 50% devaluation of the peso
• Crisis can be cause by central bank intervention.


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Other Pegged Systems
• China (1996-2005)
• Was pegged to 9.28 Yuan to the US dollar.
• US was experiencing trade deficit of 100 billion per year with
China
• US accused China of holding Yuan artificially low against dollar

• China revalued the Yuan 2.1% in July 2005
• Also agreed to allow the Yuan to float subject to .3% limit each

day from the previous day against a basket of major currencies
• 2007 China widened its band so that the Yuan value could float .
5% limit each day 6.34 Yuan to 1.00 USD
• Large US securities purchases devalues the USD to the Yuan –
capital flow from China to US offset Trade Flow

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Currency Board
a system pegging the value of local currency to some other currency
• A currency board is a monetary authority which is

required to maintain a fixed exchange rate with a foreign
currency. This policy objective requires the conventional
objectives of a central bank to be subordinated to the
exchange rate target.
• For a currency board to be successful, it must have
credibility in its promise to maintain the exchange rate.
• It has to intervene to defend its position against the
pressures exerted by economic conditions, as well as by
speculators who are betting that the board will not be able
to support the specified exchange rate.

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Exposure of a Pegged Currency to Interest
Rate Movements
• A country that uses a currency board does not have

complete control over its local interest rates, as the rates
must be aligned with the interest rates of the currency to
which the local currency is tied.
• Note that the two interest rates may not be exactly the
same because of different risks.
• A currency that is pegged to another currency will have to
move in tandem with that currency against all other
currencies.
• So, the value of a pegged currency does not necessarily
reflect the demand and supply conditions in the foreign
exchange market, and may result in uneven trade or
capital flows.
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Interest Rate of Pegged Currencies
• If a country uses pegged currency it loses some control

over its interest rates since they must align with the
interest rate of the country that it is pegged.
• For example, Hong Kong has tied the value of the Hong
Kong dollar to the U.S. dollar (HK$7.8 = $1) since 1983,
while Argentina has tied the value of its peso to the U.S.
dollar (1 peso = $1) since 1991.
• If the HK dollar is pegged to the US Dollar and HK wants to reduce

its interest rate to stimulate growth then investors are enticed to
move money to the US where interest rates are higher.
• Investors have no Exchange Rate Risk and can move monies to
USD and back to HK $ with out worry.
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Dollarization
• Formal Dollarization
• In 1990 Ecuador currency (Sucre) had depreciated by 97%
• Ecuador replaced the Sucre with the US dollar
• By 2000 inflation had declined and economic growth had
increased. In this case dollarization had a favorable effect
• Informal Dollarization
• Local merchants take and prefer dollars to local currency
• Weakens local currency which furthers the demand for more dollars.

International Executive Master of Business Administration