Thursday, January 17, 2008

Floating vs. Fixed exchange rate system

Floating currency implies that the government of the currency concerned will not interfere with the exchange rate. But this never happens in reality. The question of floating vs. fixed can be better understood by us if we know some basics about what is known as the macroeconomic trilemma (or the impossible trinity). What this says is that at the most general level, policymakers in open economies are confronted with three typically desirable, yet contradictory, objectives:

1. to stabilize the exchange rate;
2. to enjoy free international capital mobility, and
3. to engage in a monetary policy oriented toward domestic goals.

Because only two out of the three objectives can be mutually consistent, policymakers must decide which one to give up. This is the trilemma.

So even a country that country professes that it has a floating exchange rate system does intervene often in the forex markets to obtain a 'desired' level of exchange rate. That is how countries end up having only a managed float. That is they will allow their currency to float (i.e., have its exchange rate with other currencies fluctuate according to market determined forces) within a certain acceptable upper and lower bands. Only when they fail to contain it within those bands does it really become a floating currency.

Thus, a fully floating currency is an idealistic situation. Free economies claim that their currency is floating. What they are referring to is their managed float only. Even the US does manage the dollar's exchange rate to a certain extent. It will be crying hoarse only when it is unable to control it beyond a point. That is why you see it cribbing about Chinese renminbi. While it sees that there will be lot of benefit for it in the renminbi's appreciation vis a vis the dollar, China sees it the other way round and follows a fixed exchange rate system. It will allow the renminbi to appreciate only at its chosen time.

A floating currency will allow the currency to be determined by pure market's demand-supply situation. At least the theory is that this will allow its goods and services to obtain the best/realistic prices in a given time period. In a fixed exchange rate system this will be government determined. The demand that the other country should follow the same system as that of the native currency will originate only when the host country of the currency sees that it is at a disadvantageous position.

To come back to the question about the pros and cons of the free vs floating exchange rate system. A floating exchange rate system will allow free flow of capital across the borders. But one should have the appetite to take risks that go along with it. That is if the currency depreciates/appreciates, one should be ready to face the consequences. This calls for lot of hedging abilities. In a fixed exchange rate system, while this risk is absent the rate can be altered by an administrative fiat. Then also one should be ready to face the consequences of depreciation/appreciation.

1 Comment:

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