Flexible Vs. Fixed Exchange Rates

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Flexible Vs. Fixed Exchange Rates


The national currency rate is supposed to be the critical to the economic system of any country. It has a direct impact on such factors as the competitiveness of exports, the value of imports, inflation, gross domestic product, etc. However, the development of the economic relations in the world community as well as the interaction of institutional units among the different countries provide the necessity for the specific mechanism able to create the measurable quantities in order to pay for goods and services purchased abroad. The exchange rate is supposed to be such a mechanism. In fact, the exchange rate is the crucial element of the monetary system. It implies the ratio of the value of the currencies of different countries. The exchange rate helps to overcome the limitations of the national currency and provides the transformation of the local value into the international value (Kreinin 2010, p. 438). In other words, the exchange rate implies the price of the monetary unit of one country expressed in the currency of another country. This creates the uniform cost criterion, which allows organizing and regulating the foreign exchange rate process, i.e. the purchase and sale of various currencies.

The abovementioned proves that the international economic transactions are strictly related to the exchange rates of the national currencies. Such exchange takes place in certain proportions and at the certain price. Just as the price of any goods is affected by the supply and demand, the exchange rate is influenced by the great variety of factors, including the specific role played by the supply and demand for the particular currency. Taking into account the abovementioned, the following paper discusses advantages and disadvantages of fixed and floating exchange rates, and the Mundell triangle. It analyzes the optimum currency areas as well as discuss the role of the ECB. The paper also covers the issues of the real and nominal interest rates, monetary transmission mechanisms, and money illusion.

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Fixed & Flexible Exchange Rates

The fixed exchange rate implies the tough bind of the national currency to another currency or to the so-called currency basket, i.e. the set of currencies. In other words, the rate is set as the relation to the US dollar, Euro or any other currency. This policy remains the unchanged for a long time, regardless of fluctuations in the demand and supply for foreign currencies. However, the central bank still has to change the course in some periods. The official decline of the national currency is called devaluation, while its increase is called revaluation.

Floating exchange rate refers to the freely fluctuating rate of the national currency influenced by the changing supply and demand for the specific currency. While using the floating exchange rates, it is easy for the central bank to adjust the volume of the official foreign exchange reserves. At fixed rates, the risk of devastation or, alternatively, the glut of the foreign exchange reserves of the country (Dooley, Folkerts-Landau & Garber 2009). Through avoiding the abovementioned issues, the central bank is forced to resort to a revision of the official exchange rate. The floating indicators allow the flexible work of the balance of payments and the level of foreign exchange reserves.

The Mundell Triangle

All macroeconomic indicators in an open economy are largely linked to the exchange rate. To analyze the interference of the exchange rate and other macroeconomic variables, one can use one of the key macroeconomic models, i.e. IS-LM model for an open economy proposed by Robert Mundell. The model is based on the commodity market curve (IS) and the market of assets submitted by money market (curve LM). The model can be implied as the set of the three following equations:

1. (IS) Y= C(Y-T) + I(r) + G+ NX(Y,e)

2. (LM) M/P= L(r,Y)

3. r= r*

The first equation describes the curve IS. It characterizes the commodity market in an open economy. The volume of the consumption in this market depends on the rate of the disposable income (Y – T), gross private investments – I, the real interest rate – r, net exports – Xn and the real exchange rate – ε. The model is based on the assumption of the constant level of prices in the short term period. Therefore, the changes in the real exchange rate are proportional to the changes in the nominal exchange rate. The growth of the nominal exchange rate makes the domestic goods more expensive, while the import goods become cheaper, reducing exports and stimulating imports. As the result, the net exports Xn reduces. It means that the exchange rate affects the net exports, while the remaining components of the model are not linked to the exchange rate.

The second equation refers to the money market, where the supply of real money balances (M/P) equals the demand for them L (r, Y). This equation corresponds to the model LM. It is important to note that in this version of the model, the money market is not associated with a change in the exchange rate.

The third equation is new compared to the standard IS-LM model. It establishes the dependence of the internal interest rates (r) in a small open economy from the level of the global interest rate (r*). It is known that a small open economy takes the prices and interest rates of the world market, but cannot influence their formation. The model assumes the perfect capital mobility, which means the alignment of interest rates in the domestic economy and abroad, providing the flow of capital from one country to another.

The Comparative Analysis of the Fixed & Flexible Exchange Rates

If a country uses the flexible exchange rate of the national currency, the net inflow of capital into the country will determine the appreciation of the national currency. In turn, the increase of the exchange rate will lead to the reduction in net exports. The IS curve will shift to the left until the domestic interest rate equals the international rate.

If the country maintains the fixed exchange rate of its currency, and domestic interest rate is higher than the international rate (r2> r*), the central bank would intervene in the foreign exchange market, buying foreign currency and selling national currency to prevent the increase of the exchange rate above the officially recorded level. The supply of money will increase, and the LM curve will shift to the right, until the internal interest rate equals to the international and the inflow of capital stops.

Mundell’s short-term and long-term analysis lead to the same fundamental limitations of monetary policy. Under the conditions of the existence of (i) free capital mobility, the monetary policy can be directed to either (ii) the foreign target, for example, to the management of exchange rates, or to (iii) the internal goals, i.e. to control the price level, but not to all at once. This concept of the inconsistent trinity was self-evident to economists (Aizenman 2010, p.11). Nowadays, this idea is shared by most participants of the practical debate devoted to the policy of stabilization.

The Optimum Currency Areas

The basic idea of the optimal currency areas (OCA) lies in the fact that for some countries the usage of own currency for transactions within the country and with the outside world may initially be suboptimal.

The optimum currency area usually implies the region in which it is possible to use a certain currency at the lowest cost. In other words, the optimum currency area implies the geographic area within which the commonly used means of payment is either a single currency or multiple currencies, firmly attached to one another in the unlimited possibilities of conversion for the capital transactions. In this situation, all of these courses of currencies fluctuate synchronously in relation to other world currencies.

The basic requirements for the optimum currency areas include the following:

– The participating countries should share the full mobility of factors of production (labor and capital);

– The openness of the economy of the candidate countries;

– The similarity of the inflation rates;

– The diversification of the economy (the presence in one country a significant number of the single-industry regions);

– The economical and political integration.

The Role of the ECB: Fostering Employment or Checking Inflation?

The main objective of the ECB is proclaimed as the maintenance of the price stability. It involves the creation of an economic situation where the inflation rate is less than 2%. It means that the inflation rate rather than changes in the money supply is supposed to be the benchmark of the monetary policy. The EMU has the common standards for the measurement of inflation, so that it increases the reliability and facilitates the analysis of the data.

The other objectives and goals of the ECB include the following:

– The maintenance of the stable functioning of the payment system of the Euro area;

– The protection and provision of the purchasing power of Euro;

– The maintenance of the macroeconomic balance in the European Union;

– The facilitation of the smooth functioning and development of the banking system of the EU.

Real & Nominal Interest Rates. Money Illusion

The interest rate is also supposed to be one of the most important macroeconomic indicators. In fact, there are many different interest rates in the financial market. The nominal interest rate implies the market interest rate without inflation, reflecting the current assessment of the monetary assets in the market. The real interest rate is the nominal interest rate minus the expected rate of inflation.

The term ‘money illusion’ refers to the tendency of people to take the nominal value of money, rather than their real value, expressed in purchasing power. In other words, most people pay more attention to the digital par value of money, although the quantitative relations are supposed to be more important trough the purchase of goods. This misconception is caused by a lack of self-value of money, the real value of which is provided through their ability to be exchanged for the goods and services (Fehr & Tyran 2012).

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Money illusion may significantly affect the way people view the financial results. The experiments have shown that people tend to perceive as an unfair reduction of nominal income by approximately 2% without changing commodity prices. But, at the same time, the increased by 2% in nominal incomes in the simultaneous inflation of 4% is considered fair (Romer 2014). However, these two options cost almost equivalent. In addition, the money illusion leads to the fact that the nominal price changes can affect demand, even if the real purchasing ratio remains unchanged.