Fixed & Managed Exchange Rate Systems (Cambridge (CIE) A Level Economics): Revision Note

Fixed exchange rate system

• A system in which the country’s central bank intervenes in the currency market to fix (peg) the exchange rate in relation to another currency e.g US$

  • When they want their currency to appreciate, they buy it on forex markets using their foreign reserves, thus increasing its demand

  • When they want their currency to depreciate, they sell it on forex markets, thus increasing its supply

• Sometimes the peg is at parity e.g. 1 Brunei Dollar = 1 Singapore Dollar

• Often the peg is not at parity e.g. Hong Kong has pegged its currency to the US$ at a rate of HK$ 7.75 = US$ 1

• A revaluation occurs if the Central Bank decides to change the peg and increase the strength of its currency

• A devaluation occurs if the Central Bank decides to change the peg and decrease the strength of its currency

Diagram analysis

• The HK/US exchange rate is maintained at HK$7.75 = US$1 by the Hong Kong Monetary Authority (HKMA).

Left diagram — market for HK$

• Increased imports from the USA raise demand for US$ — firms must sell HK$ to buy US$, increasing the supply of HK$ on the forex market

• This puts downward pressure on HK$, depreciating it from HK$7.75 to HK$7.79 per US$1 — point 2

• To defend the peg, the HKMA buys HK$ using its US$ foreign exchange reserves, shifting the demand curve back to D₂

  • The rate returns to HK$7.75 = US$1 — point 3

Right diagram — market for US$

• The same import demand raises demand for US$, appreciating it from $1 = HK$7.75 to $1 = HK$7.99 — point 2

• The HKMA sells US$ from its reserves, increasing supply to S₂

  • The rate returns to HK$7.75 = US$1 — point 3

Key mechanism

• Both diagrams show the same intervention — the HKMA uses US$ reserves to buy HK$ simultaneously increasing HK$ demand and US$ supply

• If reserves run out, the central bank can no longer defend the peg and it collapses — this is what forced sterling out of the European Exchange Rate Mechanism in September 1992 when the Bank of England exhausted its reserves trying to support the pound

Distinction between revaluation and devaluation

• These terms apply specifically to fixed exchange rate systems, where the government actively decides to change the officially pegged rate

• Devaluation is a deliberate decision by the government to lower the official fixed exchange rate - the domestic currency is pegged at a lower value against foreign currencies

  • Makes exports cheaper and imports dearer

  • Used to improve international competitiveness and correct a persistent current account deficit

  • Example: if the rate is fixed at £1 = $2.00 and the government devalues to £1 = $1.50, sterling has been devalued by 25%

• Revaluation is a deliberate decision by the government to raise the official fixed exchange rate - the domestic currency is pegged at a higher value against foreign currencies

  • Makes exports dearer and imports cheaper

  • Used to reduce inflationary pressure from import costs, or in response to international pressure where a currency is perceived as undervalued

  • Example: China was under sustained international pressure to revalue the renminbi upwards given its persistent current account surplus

Key distinction from floating system terminology

Managed exchange rate system

• The exchange rate is allowed to fluctuate within a specified band around a desired valuation. If it goes outside of this band, the central bank will intervene to bring it back within the band

  • When they want their currency to appreciate back within the band, they buy it on forex markets using their foreign reserves, thus increasing its demand

  • When they want their currency to depreciate back into the band, they sell it on forex markets, thus increasing its supply
     

• Currently, almost all currencies are managed currencies

  • The width of the band varies from country to country

  • These bands are not published, as it would help  currency speculators to know when currency reversals would be initiated by the central bank, and they would seek to profit from that knowledge

Diagram analysis

• China has not released their currency bands, however, the value seems to fluctuate up to 2% around a value of 1US$ = 6.75 CNY

•  The initial market equilibrium is found at ER₁ Q₁

Action to correct currency appreciation

• Increased demand for the Chinese Yuan leads to a rightward shift of demand D₁→D₂ leading to an appreciation from ER₁→ER₂

• The currency is approaching the upper band so the Peoples Bank of China intervenes by selling their own currency (and buying foreign reserves)

  • This increases the supply of the Yuan causing a rightward shift from S₁→S₂

  • A new equilibrium is established at ER₁Q₃, well within the band

Action to correct currency depreciation

• Increased supply of the Chinese Yuan on world markets leads to a rightward shift of supply from S₁→S₂ leading to a depreciation from ER₁ towards the bottom currency band

• The currency is approaching the bottom band so the Peoples Bank of China intervenes by buying their own currency (and selling foreign reserves)

  • This increases the demand of the Yuan causing a rightward shift from D₁→D₂

  • A new equilibrium is established at ER₁Q₃, well within the band