IB Economics - Evaluation of Different Exchange Rate Systems

This study note for IB economics covers an Evaluation of Different Exchange Rate Systems

Exchange rate systems are essential frameworks within which countries manage the value of their currencies relative to others. Understanding the differences between fixed and floating exchange rate systems is crucial for students of economics, as these systems influence international trade, investment, and the overall economic stability of a country. This guide explores fixed and floating exchange rate systems, their pros and cons, and their impact on various economic stakeholders.

Fixed Exchange Rate System

A fixed exchange rate system, also known as a pegged exchange rate system, is one where a country’s currency value is tied or fixed to another major currency (like the US dollar or euro) or a basket of currencies.

Characteristics

• The central bank maintains the currency’s value within a narrow band or at a set rate against the chosen currency.
• Requires constant intervention by the central bank to buy/sell foreign reserves to maintain the peg.

Advantages

• Certainty for Stakeholders: Provides stability and predictability for international traders and investors, reducing exchange rate risk.
• Inflation Control: Helps to keep inflation under control if the peg is against a low-inflation currency.
• Disciplined Economic Policy: Governments are often compelled to maintain prudent fiscal and monetary policies to sustain the peg.

Disadvantages

• Loss of Monetary Policy Autonomy: The need to maintain the peg limits the central bank’s ability to set interest rates according to domestic needs.
• Vulnerability to Speculative Attacks: If market participants believe the currency is overvalued, they may speculate against it, forcing a devaluation or abandoning the peg (e.g., the 1997 Asian Financial Crisis).
• High Cost of Maintaining Reserves: Significant reserves of foreign currency are required to defend the peg, which can be costly and unsustainable in the long term.

Real-World Examples

• Hong Kong: Pegged to the US dollar, providing stability for trade and investment but limiting monetary policy flexibility.
• Denmark: Pegged to the euro within the ERM II system, allowing minor fluctuations but requiring frequent interventions to maintain the peg.

Floating Exchange Rate System

A floating exchange rate system allows the currency’s value to be determined by market forces of supply and demand relative to other currencies. No direct government or central bank intervention is required.

Characteristics

• Exchange rates fluctuate freely based on economic conditions, such as inflation, interest rates, and economic growth.
• Central banks may occasionally intervene to stabilize severe volatility but generally do not fix the rate.

Advantages

• Flexibility: Allows for automatic adjustment of the currency value in response to economic changes, helping to correct trade imbalances.
• Monetary Policy Independence: Central banks can set interest rates that suit domestic economic conditions without worrying about defending a currency peg.
• Lower Need for Reserves: Less need for large foreign exchange reserves as the market determines the rate.

Disadvantages

• Uncertainty for Stakeholders: Fluctuating rates introduce uncertainty, which can deter international trade and investment.
• Potential for Excessive Volatility: In some cases, exchange rates may be overly volatile, disrupting economic stability.
• Import-Inflation Risk: Depreciation of the currency can lead to higher import costs and inflation.

Real-World Examples

• United States: Operates a floating exchange rate, allowing the dollar to fluctuate based on economic indicators.
• Japan: Although it has a floating rate, the Bank of Japan occasionally intervenes to prevent excessive yen appreciation.

Comparative Analysis

To fully grasp the differences, let’s compare these systems based on specific factors:

1. Degree of Certainty for Stakeholders

• Fixed: High certainty due to stable exchange rates; ideal for businesses planning long-term investments.
• Floating: Low certainty as rates fluctuate; can deter international business and long-term planning.

2. Ease of Adjustment

• Fixed: Difficult to adjust; often requires significant economic restructuring or devaluation under crisis conditions.
• Floating: Easier adjustment; market forces naturally correct imbalances through currency appreciation or depreciation.

3. Role of International Reserves

• Fixed: High reserves needed for defending the peg; can strain national finances.
• Floating: Minimal reserves required; only used for occasional interventions to prevent extreme volatility.

4. Flexibility for Policymakers

• Fixed: Limited flexibility; policy tools like interest rates are geared towards maintaining the peg rather than domestic economic needs.
• Floating: Greater flexibility; policymakers can use monetary policy to target inflation, unemployment, and growth.

Glossary of Key Terms

• Appreciation: Increase in the value of a currency relative to another.
• Devaluation: Deliberate downward adjustment of a currency’s value in a fixed exchange rate system.
• Depreciation: A fall in the value of a currency in a floating exchange rate system due to market forces.
• Exchange Rate: The price of one currency in terms of another.
• Foreign Reserves: Assets held by a central bank in foreign currencies, used to back liabilities and influence monetary policy.
• Speculative Attack: A situation where investors sell off a country’s currency due to the belief that the fixed exchange rate is unsustainable.
• Volatility: The extent of variation or fluctuation in the exchange rate over time.

Possible IB Economics Essay-Style Questions

1. Evaluate the advantages and disadvantages of a fixed exchange rate system for a developing economy.
2. To what extent does a floating exchange rate system provide better economic stability than a fixed exchange rate system?
3. Discuss the impact of exchange rate systems on international trade and investment in a globalized economy.
4. Analyze the challenges faced by countries in maintaining a fixed exchange rate system in the context of speculative attacks.

Recent Real-World Data & Examples

• China: Managed float system with limited flexibility; heavy intervention by the People’s Bank of China.
• Russia (2022): Following sanctions, Russia floated the ruble, leading to extreme volatility and a significant decline in value, highlighting the risks of market-based systems under economic pressure.
• Eurozone: Member countries gave up national currencies for the euro, effectively adopting a fixed system among themselves but floating against the world.

Retrieval Questions for A-Level Students

1. What is the main difference between a fixed and a floating exchange rate system?
2. How does a fixed exchange rate system provide certainty to international investors?
3. Why might a country need large foreign reserves under a fixed exchange rate system?
4. What are the advantages of having a floating exchange rate for a country’s monetary policy?
5. Can you name a real-world example of a country using a fixed exchange rate system?

These study notes should give you a comprehensive understanding of the differences, advantages, and challenges of fixed and floating exchange rate systems. For further learning, consider applying this knowledge to current events and global economic scenarios.