IB Docs (2) Team
Fixed / managed exchange rate systems (some HL tasks)
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Introduction
This lesson looks at a comparison of fixed and floating exchange rate systems.
Enquiry question
What are the differences between a floating exchange rate system and a fixed / managed rate system?
Lesson time: 70 minutes
Lesson objectives:
Describe a fixed exchange rate system involving commitment to a single fixed rate.
Distinguish between a devaluation of a currency and a revaluation of a currency.
Explain, using a diagram, how a fixed exchange rate is maintained.
Explain how a managed exchange rate operates, with reference to the fact that there is a periodic government intervention to influence the value of an exchange rate.
Distinguish between a depreciation of the currency and an appreciation of the currency.
Compare and contrast a fixed exchange rate system with an exchange rate system, with reference to factors including the degree of certainty for stakeholders, ease of adjustment, the role of international reserves in the form of foreign currencies and flexibility offered to policy makers.
Teacher notes:
1. Beginning activity - begin with the opening question and then discuss this as a class. (Allow 5 minutes in total)
2. Processes - technical vocabulary - the students can learn the background information from the videos, activities 1 - 4 and the list of key terms. (30 minutes)
3. Applying the theory - activities 5 and 6 contain a video and make effective areas for discussion. (20 minutes)
4. Developing the theory - activity 7 focuses on the benefits and costs of fixed v floating exchange rate systems, from the viewpoint of an LEDC. (15 minutes)
Key terms:
Devaluation - when the value of a nation's currency falls, relative to other currencies, as a result of a deliberate policy decision by the government or central bank.
Revaluation - when the value of a nation's currency rises, relative to other currencies, as a result of a deliberate policy decision by the government or central bank.
Appreciation - when the value of a nation's currency rises, relative to other currencies, as a result of a market forces, rather than deliberate actions of the government or central bank.
Depreciation - when the value of a nation's currency falls, relative to other currencies, as a result of a market forces, rather than deliberate actions of the government or central bank.
Fixed exchange rate system - an exchange rate regime applied by a government or central bank which ties a country's official exchange rate to another country's currency (usually the $ or Є) or the price of gold.
Managed exchange rate system - the exchange rate system employed by many modern economies. Under this system the exchange rate is allowed to fluctuate, but central banks will influence the exchange rates to maintain a certain range.
The activities on this page are available as a PDF file at: 
Fixed exchange rate systems
Opening activity
(a) Investigate which countries use the US$ as a medium of exchange, rather than their own currency?
Ecuador, East Timor, El Salvador, Marshall Islands, Micronesia, Palau, Turks and Caicos, British Virgin Islands, Zimbabwe.
Which nations use the Euro as a system of currency (besides those nations in the Eurozone)?
Andorra, Kosovo, Monaco, Montenegro, San Marino, Vatican City.
Activity 2: Investigation
Watch the following short video which explains the difference between the three different exchange rate systems and then complete the tasks which follow:
1. Investigate some of the nations using a fixed exchange rate system.
| Country | Region | Currency pegged to |
Bahrain | Middle east | USD |
Bulgaria | Europe | EUR |
Denmark | Europe | EUR |
Hong Kong | Asia | USD |
Ivory Coast | Africa | EUR |
Qatar | Middle east | USD |
Republic of the Congo | Africa | EUR |
Saudi Arabia | Middle east | USD |
| United Arab Emirates | Middle east | USD |
2. Explain the main differences between fixed, floating and managed exchange rate systems (HL only).
Hint:
The differences are as follows:
Under a floating exchange rate system the exchange rate is determined by the forces of demand and supply.
By contrast under a fixed exchange rate system the exchange rate is determined by governments. The central bank intervenes in the foreign exchange market to keep the exchange rate within its market equilibrium.
Under a managed exchange rate system the exchange rate is determined by supply and demand, but central banks will intervene to maintain the exchange rate within a certain range.
3. What is the difference between a currency devaluation and a currency depreciation?
| Impact on the currency value | Fixed rate or managed exchange rate system | Floating exchange rate system |
| Fall in Value | By contrast a devaluation occurs within a fixed exchange rate when the central bank intervenes to reduce the value of the currency. | Depreciation of a currency happens when the price of a currency is forced down by the forces of supply and demand. |
| Rise in value | A revaluation is determined by central banks within a fixed exchange system. | A currency appreciation occurs within a floating exchange rate system and is determined by market forces. |
Activity 3: Fixed exchange rate systems
An example of a nation with a fixed exchange rate system is Saudi Arabia, which fixes the value of its currency at the rate of 3.75 to the US$.
(a) A rise in the price of oil forces up demand for the SR. Explain what action the Saudi central bank might take in order to maintain the fixed rate of 3.75 = $. Illustrate this on the diagram.
The central bank will intervene in the currency market by selling its own currency in order to maintain the market equilibrium.
(b) What action would the central bank need to take in order to support the currency following a fall in demand for the SR?
The government could provide support the currency by purchasing the surplus currency itself, using its own foreign currency reserves.
Activity 4: Managed exchange rate systems
The diagram to the right illustrates the market for £s, relative to the US$. The equilibrium exchange rate is 1.4 to the $. The UK government operates a managed exchange rate of between 1.3 and 1.5 $ to the £.
(a) A rise in the popularity of London as a tourist destination, forces up the price of the £ close to its upper band. Illustrate this on the diagram and explain the action the UK central bank might take to correct the £'s appreciation.
The UK government must sell its own currency in order to keep the £ within its preferred range.
(b) Explain what action the UK government would need to take if the UK £ were to fall close to the bottom of its range?
The Bank of England would need to use its reserves of US $ (and perhaps other currencies) to purchase £s to increase the demand for sterling.
(c) Why does the above highlight one of the weaknesses of fixed / managed exchange rate systems?
Countries maintaining a fixed or managed exchange rate system will need to hold sufficient reserves of foreign currency to intervene in the currency market .
(d) What course of action can a central bank take once the reserves of a central bank run out?
One cause of action for the central bank is to make changes to its central bank interest rate to maintain £ within the preferred range. If the central bank raises interest rates then this will result in a net inflow of investment capital into the country. If the central bank reduces interest rates then the country will attract less investment flows (called hot money flows) and overseas demand for the currency will fall.
Activity 5: A comparison of fixed vs floating exchange rates (HL only)
Watch the following short video from AEI scholar Derek Scissors who defines and compares fixed vs floating exchange rates as part of this Tax Foundation University lecture series on the economics of trade. Afterwards complete the student discussion point.
(a) Why according to the video do fixed exchange rates not provide stability for the markets?
Because it creates a false market situation - what Derek Scissors calls false stability.
(b) Are floating exchange rates market determined?
Because the government / central bank is the sole provider of the supply of money - has a monopoly on supply.
(c) Why does the video advise against a nation devaluing its currency?
Because a weaker currency reduces spending power for its citizens, reducing real income levels.
(d) What circumstance does the video describe as the only one in which a competitive devaluation is the correct case of action.
When a country had a currency crisis and devaluation is a temporary and emergency measure in order to gain hard currency.
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Activity 6: Fix or float, sink or swim?
Taken from the Economist at: http://www.economist.com/node/597868
THESE are jittery times for emerging-market currencies. Having survived an onslaught from speculators last month, the Thai baht plunged on June 19th after the resignation of the country's finance minister, Amnuay Viravan. The previous day Mr Amnuay's Israeli counterpart, Dan Meridor, had quit after a quarrel over how best to tame the soaring shekel. A few weeks ago the Czech Republic was forced to float the koruna (and lost its finance minister as well). Its neighbour Slovakia is now thought to be in the market's sights.
These episodes are a lesson that global capital markets do not leave macroeconomic mistakes unpunished for long: the Thais ran up a current-account deficit of 8% of GDP last year, the Czechs 8.6% and the Slovaks 10.1%. But, more than this, they raise a broader question: should emerging economies fix their exchange rates at all?
The debate about whether it is better to fix exchange rates or let currencies float is one of the longest-running in economics. Both approaches have their merits. A floating rate can help a country cope with a sudden drop in the price of its exports or a surge of foreign capital. This should be attractive to emerging economies, which are especially vulnerable to such shocks.
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Fixed rates have proved invaluable in cutting inflation where it had been out of control. A few years ago, Latin America and Eastern Europe were ravaged by inflation. Now, in Argentina, for instance, inflation is expected to be about 1% this year, compared with 27% a month in early 1991.
Yet exchange-rate straitjackets can become increasingly uncomfortable. Some countries have seen their real exchange rates (ie, the rate once inflation differentials are taken into account) rise sharply, hurting the competitiveness of their industries, in part because inflation does not fall overnight to the levels of rich countries. In the Czech Republic, the real exchange rate strengthened by 42% between January 1993 and February 1997; in Brazil, it has risen by 26% since June 1994 (see chart).
An additional worry is the huge inflow of foreign capital that a newly stabilised country often attracts. Yet if the capital suddenly flees, these countries face a painful downward adjustment of domestic wages and prices.
Student work point
Using extracts from the passage above and your knowledge of economics explain why many Developing nations prefer to adopt a fixed exchange rate system?
Many of the advantages of fixed exchange rate systems are particularly relevant to emerging markets.
The article states that 'Latin America and Eastern Europe were ravaged by inflation. Now in Argentina for instance, (because of a fixed exchange rate system) inflation is expected to be about 1% this year, compared with 27% a month in early 1991'.
Many emerging economies also suffer from a lack of capital and investment and as the final paragraph of the article outlines, it is likely 
that a fast growing LEDC, which fixes its exchange rate will be able to attract significant inflows of foreign capital.
On the other hand there are also disadvantages of an emerging economy implementing a fixed exchange rate system. For example paragraph 3 states that: ' A floating rate can help a country cope with a sudden drop in the price of its exports or a surge of foreign capital. This should be attractive to emerging economies, which are especially vulnerable to such shocks.'
Many LEDCs may also find it difficult to allocate sufficient foreign currency reserves to the central bank so that it can implement the plan. Those scarce currency reserves could otherwise be employed elsewhere in the economy. An economy adopting a fixed exchange rate system is also likely to require a policy of high interest rates which may suppress economic growth, by reducing consumption and investment level in the economy.
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