By Omar El-Sharawy
February 19, 2018
Analysts agree that “getting the exchange rate right” is essential for economic stability and growth. Over the past two decades, many developing countries have shifted away from fixed exchange rates and towards flexible exchange rates. The question remains, why are flexible exchange rates preferred?
A flexible exchange rate is an exchange rate which fluctuates depending on the supply and demand for the corresponding currency in relation to other currencies. If there is a high demand for a particular currency, it’s exchange rate relative to other currencies increases. On the other hand, if there is less demand, the value decreases. A fixed exchange rate however, indicates that a nation’s dollar is always convertible to other currencies in a fixed ratio because of government intervention. Another term used to explain a fixed exchange rate is “pegging” or a pegged exchange rate. (Pegging is used to try and stabilize a country’s currency by fixing its exchange rate to that of another country, most commonly the United States).
Between 1870 and 1914, there was a global fixed exchange rate. Currencies were linked to gold, meaning that the value of a local currency was fixed at a set exchange rate to gold ounces. This was known as the gold standard. Toward the end of WWII, world leaders gathered in Bretton Woods, New Hampshire in an effort to generate global economic stability following the devastation of the war. At the Bretton Woods conference basic rules and regulations governing international exchange were established in the hopes of promoting foreign trade and of maintaining the monetary stability of nations and by extension, that of the global economy. These regulations included the obligation for member states that their currency be convertible to gold in a fixed proportion (as was the US dollar). Since the early 1980s, however, developing countries have shifted away from currency pegs towards more flexible exchange rate systems.
This may be because fixed (pegged) exchange rates ultimately provide very few benefits while elevating the risks for a nation’s monetary stability. A country may decide to peg it’s currency to create a stable atmosphere for foreign investment. With a peg, the investor will always know what their investment’s value is, and therefore will not have to worry about daily fluctuations. A pegged currency can also help to lower inflation rates and generate demand, as a result of greater confidence in the stability of the currency. In recent times many economists have blamed the volatility of currency and interest rates to flexible exchange rates. But are these exchange rates at fault? No. Blaming flexible exchange rates is like blaming the messenger for bad news.
Fixed exchange regimes have led to severe financial crises; In Mexico (1995), Asia (1997) and Russia (1997) financial crises have all originated because of the difficulty in maintaining a currency peg in the long run. Attempts to maintain the high value of a local currency (relative to the pegged value) resulted in these currencies becoming overvalued and to a depletion of foreign reserves. This depletion meant that these governments could no longer meet the demand to convert the local currency into the foreign currency at the pegged rate which resulted in investor panic and a litany of other negative economic shocks.
The trend toward greater exchange rate flexibility has also been associated with more open, outward-looking policies on trade and investment and an increased emphasis on market-determined interest rates. Flexible exchange rates can also act as shock-absorbers throughout an economic crisis or implementation of a monetary policy.
In Flexible Exchange Rates as Shock Absorbers, co-authors Sebastian Edwards and Eduardo Levy Yeyati examine the impact of terms-of-trade shocks on economies with different exchange rate regimes. Edwards and Levy Yeyati found that economies with flexible exchange rates grow more rapidly than those with fixed regimes. The difference in the rate of growth of GDP per capita is substantial, ranging from 0.66% to 0.85% more per year for countries with flexible systems. Additionally, “Under flexible exchange rates the effects of terms-of-trade shocks on growth are approximately one half that under pegged regimes.”
Trade-offs exist between fixed and flexible regimes. If economic policy is based on the “anchor” of a currency peg, monetary policy must be subordinated to the needs of maintaining the peg. As a result the burden of adjustment to shocks falls largely on fiscal policy (government spending and tax policies). For a peg to be sustainable on the long-run, it must be credible. In practice this often means that fiscal policy must be flexible enough to respond to shocks. Under a flexible exchange rate, domestic economies have a shock absorbing system, limiting negative externalities from financial counterparts elsewhere in the world.
Although the peg has worked in the past to create global trade and monetary stability, it was utilized primarily while the rest of the world also adopted a fixed system. While a floating regime is not without its flaws, it has proven to be a more efficient means of determining the long-term value of a currency and creating equilibrium in the international market.