Fixed Exchange Rate Systems

There are two methods to operating a fixed exchange rate. The first is called a non-cooperative system and the other is a cooperative system. A non-cooperative system is one in which one country unilaterally decides to fix its exchange rate to that of another country’s currency. A cooperative in which two countries decide together to keep the exchange rate fixed between their currencies are work together to make that happen. We will begin with the non-cooperative system.

Non-Cooperative Fixed Exchange Rate System

Recall we had showed that a central bank can fix the exchange rate by being willing and able to supply foreign currency at the fixed exchange rate. We now illustrate this in a very simple graph. Suppose the central bank wants an exchange rate of , where e is measured as (amount of R.O./ 1 unit of foreign currency). Now suppose the demand for foreign currency is D1, as in the graph below. To ensure the exchange rate is the central bank must supply the amount S1. Hence the central bank must have reserves of foreign currency. Moreover, if demand rises to D2, then the central bank must now supply the amount S2, again using reserves of foreign currency. Such a process is called “defending the exchange rate”. That is, the central bank is defending the exchange rate against events that would reduce the value of the domestic currency.

The Cost of Defending the Exchange Rate

Where does the central bank get reserves of foreign currency? Under what is called a non-cooperative system, the central bank must have acquired the foreign currency by purchasing it on foreign exchange markets. Hence it must use real resources of the economy to acquire foreign currency. Indeed, in the above graph when the demand for foreign currency increases, the increase in foreign currency supplied out of the central bank reserves represents a reduction in the wealth of domestic citizens. Who gets this wealth? It goes to the foreign citizens that hold and use that foreign currency. So defending the fixed exchange rate system can be costly and can result in a transfer of wealth from domestic citizens to foreign citizens.

Limited Commitment to the Fixed Exchange Rate and a Currency Crisis

Another problem with a fixed exchange rate system is the possibility of a currency crisis. Suppose demand for foreign currency increases, as in the above graph, and continues to increase. Eventually the central bank will not have reserves of that currency. So it must use gold, bonds, or other national assets to acquire these reserves. At some point it is possible that this “taxation” on the public is so high that the central bank will decide not to defend the exchange rate. In this case, they may switch to a flexible exchange rate system, or devalue the domestic currency. This is pictured below. The demand rises to D3, at which point the central bank does not increase supply. Hence the exchange rate rises to its new equilibrium, e3.

Now notice a problem the domestic economy faces. When the demand increased to D2, the central bank defended the exchange rate by using up its reserves. This effectively taxes its people transferring wealth to foreign citizens. However, as demand continued to rise to D3 the central bank stops trying to defend the exchange rate and devalues the currency. Thus, in the end, the taxation of the domestic citizens that occurred earlier was for nothing.

Speculators and Currency Crises

Consider again a country operating that has limited commitment to a fixed exchange rate in a non-cooperative setting. In such a situation speculative activity can cause a currency crisis in which the central bank devalues the currency. Recall such a crisis situation arises when the demand for foreign currency rises to such an extent that the central bank is no longer willing to defend the exchange rate, as it has now become to expensive to defend. What we want to show is that speculative activity can cause the demand for foreign currency to rise to such an extent that the domestic currency is devalued.

What is speculative activity? In general, speculators make money by buying when things have a low price and selling when they have a high price. As it applies to currency, they buy currency when a relatively low price and sell at a high price. Now suppose that the exchange rate today is ea,b = 2. This means it takes 2a to buy 1b. But suppose tomorrow the exchange rate will be ea,b = 4. This means 4a will buy 1b, or 1b will buy 4a. Consider how a speculator could make money. He exchanges 2a today for 1b. Tomorrow he exchanges that 1b to buy 4a. Hence in one day he has doubles his money; 2a has been converted into 4a. Thus speculators can make money if currency a is devalued.

It is the profit they make when currency a is devalued that causes the problem. Because they way they make money is to exchange currency a for currency b today; that is, their speculative activity increases the demand for foreign currency making it more likely that a devaluation will occur.

Now one might think that they face risks if a devaluation does not occur. In fact this is not true. The reason is simple. Suppose that they buy foreign currency at the rate of 2a for 1b. That is, they use 2a to buy 1b. Now suppose no devaluation occurs. That means in the future they will trade that 1b for 2a. Hence they lose nothing. So we have the following:

  • If devaluation occurs, speculators win.
  • If devaluation does not occur, speculators neither win nor lose.

Hence speculative activity is a no lose proposition. Thus anytime speculators believe a government is getting close to their limit on willingness to defend the exchange rate, they will engage in speculative activity which makes a currency crisis more likely.

Hence a non-cooperative system of fixed exchange rates can be costly, it is susceptible to a crisis, encourages speculation that undermines the fixed exchange rate system, and ultimately may not even be able to fix the exchange rate.

Cooperative Fixed Exchange Rates

A cooperative system of fixed exchange rates is when the domestic and foreign governments work together to keep the exchange rate fixed. To see how this works, recall all the negative effects of a non-cooperative system occur due to the potential increase in demand for foreign currency. Under a non-cooperative system the domestic country must use their own wealth to acquire to meet the demand for foreign currency and defend the exchange rate. But with a cooperative system the foreign government supplies the additional currency needed when demand for foreign currency rises. That is, instead of the central bank getting reserves by purchasing foreign currency on the market, it gets them for free from the foreign government. Since they are for free the exchange rate is always defended, wealth is not transferred from domestic to foreign citizens, no currency crisis can occur, and there is never a situation in which speculative activity will profit the speculators. Hence cooperative fixed exchange rate systems are preferable to non-cooperative fixed exchange rate systems.

Currency Unions

We have made the argument that cooperative fixed exchange rate systems are preferable to non-cooperative fixed exchange rate systems. What about currency unions? A currency union is when countries in a region all adopt the same currency. Currency unions are effectively a type of cooperative exchange rate system where the exchange rate is fixed at 1a for 1b. Also similar to cooperative fixed exchange rates, their must be cooperation among the member countries in managing the money supply. Because currency unions are like cooperative fixed exchange rates, there is certainly value to a currency union. The primary difficulty is a political one. Who gets to control the money supply? Will small countries have equal rights as large countries? Despite these difficulties there are probably substantial gains from currency unions.

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