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IBEconomicsDPHLRevision Notes4. The Global Economy4.5 Exchange RatesFixed Versus Floating Exchange rate Systems

Fixed Versus Floating Exchange rate Systems (DP IB Economics)

Revision Note

Steve Vorster

Written by: Steve Vorster

Reviewed by: Jenna Quinn

Comparing Fixed & Floating Exchange Rate Systems

  • Many countries have attempted to use fixed exchange rate systems at some point in their history 

  • Changes to the global or national equilibrium may cause Central Banks to consider which system may be most beneficial to achieving their macroeconomic goals at a specific point in time

    • A fixed exchange rate system offers stability, reduces speculative activities, but limits monetary policy autonomy

    • A floating exchange rate system allows for flexibility in monetary policy, automatic adjustments to economic conditions, but introduces greater exchange rate volatility 

  • The choice between the two systems depends on a country's macroeconomic goals, stability objectives, and the external economic environment
     

A Comparison of a Fixed and Floating Exchange Rate System


Fixed Exchange Rate System


Floating Exchange Rate System

  • The central bank actively intervenes to maintain the fixed rate

  • The currency's value is determined by market forces of supply and demand

  • Provides stability and predictability for international trade and investment

  • Allows for greater flexibility in conducting independent monetary policy as interest rates and the money supply can be more easily manipulated

  • Limits a country's ability to independently conduct monetary policy as the focus is on exchange rate and not the interest rate

  • Allows for automatic adjustments to external shocks and changes in economic fundamentals

    • Markets respond to changing fundamentals without the need for central bank intervention

  • Lowers speculative trading and currency volatility

 

Changing from one System to the Other

  • Central Banks have to consider the impact of changing from one exchange rate system to another
     

swiss-remove-euro-peg

Within a few minutes of removing the PEG, €1 = 0.90 CHF - the Swiss Franc had appreciated
 (Source: FT.Com)
 

  • In January 2015 the Swiss Central Bank removed the fixed exchange rate (peg) of €1 = 1.2 CHF and allowed the currency to float freely

  • They did this because:

    • In the face of ongoing significant demand for their own currency, the Central Bank was using enormous reserves to supply more CHF to the market in order to maintain the peg

    • They could no longer afford to supply their own currency

    • The demand for their currency was partly driven by deteriorating conditions in Russia as Russia had taken over the Crimea, which caused investors to seek safe haven for their money in Switzerland
        

The Implications of Changing from one System to Another - Real World Example


Impact


Explanation

Currency Appreciation

  • The Swiss Franc (CHF) experienced a significant increase in value against the Euro (EUR) as investors demanded it

Export Challenges

  • Swiss exporters faced difficulties as the stronger Swiss Franc made their products more expensive and less competitive in international markets

Impact on Tourism

  • The higher Swiss Franc made Switzerland a more expensive destination for foreign tourists, leading to a decrease in tourism revenue

Financial Market Turmoil

  • The sudden and unexpected appreciation of the Swiss Franc caused market turbulence and financial losses for investors holding Swiss Franc-denominated assets

Deflationary Pressure

  • The currency appreciation increased deflationary pressures in Switzerland, as imported goods became cheaper and domestic producers faced greater competition

Monetary Policy Challenges

  • The Swiss National Bank faced challenges in managing the exchange rate and preventing excessive appreciation while implementing independent monetary policy measures

Global Implications

  • The Swiss Franc's appreciation had repercussions beyond Switzerland, putting pressure on neighbouring countries and trading partners and affecting their exports and competitiveness

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    Previous:Causes & Consequences of Exchange Rate FluctuationsNext:Components of The Balance Of Payments
    Author
    Reviewer
    Steve Vorster

    Author: Steve Vorster

    Expertise: Economics & Business Subject Lead

    Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.

    Jenna Quinn

    Author: Jenna Quinn

    Expertise: Head of New Subjects

    Jenna studied at Cardiff University before training to become a science teacher at the University of Bath specialising in Biology (although she loves teaching all three sciences at GCSE level!). Teaching is her passion, and with 10 years experience teaching across a wide range of specifications – from GCSE and A Level Biology in the UK to IGCSE and IB Biology internationally – she knows what is required to pass those Biology exams.