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A

Seminar Term Paper

On

FLOATING EXCHANGE RATES AND

VARIOUS OTHER CONTEMPORARY EXCHANGE RATE ARRANGEMENTS 

Submitted To

Mr. Yogesh Satyal

Course Instructor (International Business)

Ace Institute of Management

Submitted By

Anish Man Singh Basnyat

Kamalesh Sthapit

Prakash Koju

Shradda Tiwari

MBAe, Section B, Trim. IV, Spring 2013

Ace Institute of Management

Date of Submission: August 21, 2013

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Floating exchange rates and various other

contemporary exchange rate arrangements 

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1 Concept of Exchange Rate

Exchange rate is the value of one currency compared to another. In other

words, it’s an expression of national currency’s quotation in respect to

foreign ones. For example, if 1 Indian rupee is worth 1.6 Nepalese rupees,

then the exchange rate of Indian currency is 1.6 Nepalese currencies. If something costs NRs. 160/-, then it automatically costs INR 100/- as a

matter of accountancy.

Thus, exchange rate is a conversion factor, a multiplier or a ratio depending

on the direction of conversion.

Types:

Types of Exchange Rate 

One way of classifying the exchange rate is based upon rates established on

a specific trade market- nominal exchange rates and real exchange rates.

i. Nominal exchange rates are established on currency financial

markets called "forex markets", which are similar to stock exchange

markets. Central bank may also fix the nominal exchange rate.

ii. Real exchange rates are nominal rate corrected somehow by

inflation measures. For instance, if a country A has an inflation rate of 

10%, country B an inflation of 5%, and no changes in the nominalexchange rate took place, then country A has now a currency whose real

value is 10% - 5% = 5% higher than before. In fact, higher prices mean

an appreciation of the real exchange rate, other things remaining same.

Another classification of exchange rates is based on the number of 

currencies taken into account- Bilateral and Multilateral exchange rates.

a. Bilateral exchange rates clearly relate to two countries' currencies.

They are usually the results of matching of demand and supply on

financial markets or in banking transaction. In this case of bankingtransaction, the central bank acts usually as one of the sides of the

relationship.

Other bilateral exchange rates may be simply computed from triangular

relationships: if the exchange rate Dollar-NRs is 100 and the Dollar-Yen

is 10,000 then, as a matter of computation, NRs 1 is worth 100 Yen. No

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direct NRs-Yen transaction needs to take place. If, instead, a financial

market exists for Nepalese Rupees to be exchanged with Yen, the

expectation is that actions by speculators (arbitrage among markets) will

bring the parity of 100 Yen per rupee as an effect.

b. Multilateral exchange rates are computed in order to judge thegeneral dynamics of a country's currency toward the rest of the world.

One takes a basket of different currencies, select a (more or less)

meaningful set of relative weights, then computes the "effective"

exchange rate of that country's currency.

For instance, having a basket made up of 40% US Dollars and 60%

German Marks, a currency that suffered from a value loss of 10% in

respect to Dollar and 40% to Mark will be said having faced an

"effective" loss of 10%x0.4 + 40%x0.6 = 28%.

Some countries impose the existence of more than one exchange rate,

depending on the type and the subjects of the transaction. Multiple

exchange rates then exist, usually referring to commercial vs. public

transactions or consumption and investment imports. This situation

requires always some degree of capital controls.

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2 Exchange Rate Regimes

An exchange-rate regime is the way an authority manages its currency in

relation to other currencies and the foreign exchange market.  A country’s

exchange rate regime governs its exchange rate—that is, how much its own

currency is worth in terms of the currencies of other countries.

Let’s have a scenario; A owner of a Pacific island surfboard shop, whether he

knows it or not, thinking in March about the cost of buying 100 surfboards

from his California supplier in July, should care about his country’s exchange

rate regime. If the surfboard shop owner’s country has a fixed exchange rate

regime, under which the value of the local currency is tied to that of the US

Dollar, then he can be confident that the price of surfboards in his currency

won’t change over the coming months. By contrast, if his country has a

flexible exchange rate regime vis-à-vis the US Dollar, then its currency couldgo up or down in value during the change of seasons and he may want to

allocate more, or less, local currency for his forthcoming surfboard purchase.

If we extend the above scenario to all cross-country transactions, we can

see that the exchange rate regime has a big impact on world trade and

financial flows. And the volume of transactions and the speed, at which they

are growing, highlight the crucial role of the exchange rate in today’s world,

thereby making the exchange rate regime a central piece of any national

economic policy framework.

Types of Exchange Rate Regime

The basically the exchange rate regimes are categorized into three types:

Floating exchange rate, where the market dictates movements in the

exchange rate; Pegged float, where a central bank keeps the rate from

deviating around a target band or value; and Fixed exchange rate, which

ties the currency to another currency, mostly more widespread currencies

such as the U.S. dollar or the euro or a basket of currencies.

(A)  Floating Exchange Rate

When the exchange rate can freely move, assuming any value that

demand and supply jointly establish, "freely floating exchange rate" will

be the name of currency institutional regime. Equivalently, it is called

"flexible" exchange rate as well. As the name implies, the floating

exchange rate is mainly market determined.

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In countries that allow their exchange rates to float, the central banks

intervene (through purchases or sales of foreign currency in exchange for

local currency) mostly to limit short-term exchange rate fluctuations.

Therefor these regimes are often called managed float or dirty float. 

However, in a few countries (for example, New Zealand, Sweden, Iceland,the United States, and those in the euro area), the central banks almost

never intervene to manage the exchange rates.

Floating regimes offer countries the advantage of maintaining an

independent monetary policy. In such countries, the foreign exchange

and other financial markets must be deep enough to absorb shocks

without large exchange rate changes. Also, financial instruments must be

available to hedge the risks posed by a fluctuating exchange rate. Almost

all advanced economies have floating regimes, as do most large emerging

market countries.

Free float regime 

Managed float regime 

Different types of currency peg 

Usage of foreign currency

Source: http://en.wikipedia.org/wiki/File:Currency_Exchange_regimes.png 

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In "freely" and "managed" floating regimes, a loss in currency value is

conventionally called  ―depreciation‖ , whereas an increase of currency's

international value will be called "appreciation". If the dollar rises from

NRs 80 to NRs 100, then it has shown an appreciation of 25%.

Symmetrically, the NRs has undergone an 8% depreciation.Because of appreciation in exchange rate, the import price will fall and

export price will rise. Similarly the impact of depreciation on business will

result in rise of import price and fall of export price.

But central banks can also declare a fixed exchange rate, offering to

supply or buy any quantity of domestic or foreign currencies at that rate.

In this case, one talks of a "fixed exchange rate".

Under this regime, a loss of value, usually forced by market or a

purposeful policy action, is called "devaluation", whereas an increase of 

international value is a "revaluation".

(B)  Pegged float (soft peg) exchange rate

Currencies that maintain a stable value against an anchor currency or a

composite of currencies are called pegged float exchange rates. Pegged

floating currencies are pegged to some band or value, either fixed or

periodically adjusted. That is, the exchange rate can be pegged to the

anchor within a narrow (+1 or –1 percent) or a wide (up to +30 or –30

percent) range, and, in some cases, the peg moves up or down over

time—usually depending on differences in inflation rates across countries.

So the pegged float exchange rate can be classified into

i. Crawling bands: the rate is allowed to fluctuate in a band around a

central value, which is adjusted periodically. This is done at a

preannounced rate (normally within±1%) or in a controlled way

following economic indicators. 

ii. Crawling pegs: the rate itself is fixed, and adjusted as above.

iii. Pegged with horizontal bands: the rate is allowed to fluctuate in a

fixed band (bigger than 1%) around a central rate.

Although soft pegs maintain a firm ―nominal anchor‖ (that is, a nominal

price or quantity that serves as a target for monetary policy) to settle

inflation expectations, they allow for a limited degree of monetary policy

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3 Analyses

As floating exchange rates automatically adjust, they enable a country to

reduce the impact of shocks and global business cycles, and to preempt the

possibility of having a balance of payments crisis. However, they also

engender unpredictability as the result of their dynamism.

On the other hand, in certain situations, fixed exchange rates may be

preferable for their greater stability and certainty. That may not necessarily

be true, considering the results of countries that attempt to keep the prices

of their currency "strong" or "high" relative to others, such as the UK.

The primary argument for a floating exchange rate is that it allows monetary

policies to be useful for other purposes. Under fixed rates, monetary policy is

committed to the single goal of maintaining exchange rate at its announced

level. Yet the exchange rate is only one of the many macroeconomic

variables that monetary policy can influence. A system of floating exchange

rates leaves monetary policy makers free to pursue other goals such as

stabilizing employment or prices.

The debate of making a choice between fixed and floating exchange rate

regimes is set forth by the Mundell–Fleming model (Impossible Trinity),

which argues that an economy (or the government) cannot simultaneously

maintain a fixed exchange rate, free capital movement, and an independent

monetary policy. It must choose any two for control and leave the other tomarket forces.

Nepal has been maintaining a pegged exchange rate to the Indian rupee for

a long time. The peg of NRs1.60= IRs 1.0 has not been revised since 1993. 

US

ChinaNepal

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Conclusion/Recommendation:

Whether the exchange rate system is floating, fixed or a combination of the

two, there is no way that a country can insulate itself from external factors.

It is an illusion to think that the floating rate system provides an escape

route. This lack of insulation enforces interdependence. The more dominantan economy the more wide spread is the impact of its domestic economic

policy on other countries. Therefore a satisfactory exchange rate system can

emerge only if macro-economic policies of the major industrial countries are

stable, mutually consistent and conducive to satisfactory performance of the

world economy.

Because the exchange rate regime is an important part of every country’s

economic and monetary policy, policymakers need a common language for

discussing exchange rate matters. After all, an exchange rate regime thatlooks soft to one observer may look hard to another—which reflects, among

other things, a lack of information among different players about foreign

exchange markets and about purchases or sales of foreign exchange by

central banks.

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Sources:

http://economicswebinstitute.org/glossary/exchrate.htm

Exchange Rate Regimes by Mark Stone, Harald Anderson, and Romain Veyrune

(http://www.imf.org/external/pubs/ft/fandd/2008/03/pdf/basics.pdf) 

http://en.wikipedia.org/wiki/Floating_exchange_rate 

http://www.answers.com/topic/floating-exchange-rate