IB Economics - Fixed and Managed Exchange Rates

This study note for IB economics covers Fixed and Managed Exchange Rates

Exchange rates play a crucial role in international economics as they determine the value of one currency in terms of another. Understanding how fixed and managed exchange rate systems work is essential for IB and undergraduate economics students. This study note provides an in-depth exploration of these systems, with real-world examples, key concepts, and relevant data to enhance your understanding.

Fixed Exchange Rates

Definition: A fixed exchange rate system is one where a country’s currency value is pegged to another major currency (like the US dollar) or a basket of currencies. The government or central bank commits to maintaining the currency at this fixed rate, intervening in the foreign exchange market to stabilize it when necessary.

Key Features:

• Commitment to a Single Fixed Rate: The country commits to maintaining the exchange rate at a predetermined level. For example, the Hong Kong dollar is pegged to the US dollar at a rate of approximately HKD 7.8 = USD 1.
• Central Bank Intervention: To maintain the fixed rate, the central bank buys or sells its own currency in exchange for the foreign currency to which it is pegged.
• Foreign Exchange Reserves: The central bank must hold large reserves of foreign currencies to defend the fixed rate.

Advantages of Fixed Exchange Rates:

• Stability: Provides exchange rate stability, reducing uncertainty in international trade and investment.
• Inflation Control: Can help control inflation, as the fixed rate often requires tight monetary policy.
• Predictability: Businesses and investors can plan long-term investments with more certainty.

Disadvantages of Fixed Exchange Rates:

• Requires Large Reserves: Maintaining a fixed exchange rate can drain a country’s foreign exchange reserves.
• Lack of Flexibility: The economy cannot adjust to external shocks (e.g., changes in global demand) as easily as with a floating rate.
• Risk of Speculative Attacks: If markets believe the fixed rate is unsustainable, they might speculate against the currency, leading to financial crises (e.g., the 1992 ERM crisis with the British pound).

Devaluation vs. Revaluation:

• Devaluation: A deliberate downward adjustment of the currency's value by the government in a fixed exchange rate system. For example, if the Chinese yuan is devalued from 6.3 to 6.5 per USD, it makes Chinese goods cheaper internationally, boosting exports.
• Revaluation: An upward adjustment of the currency's value in a fixed exchange rate system. For instance, if the Chinese government revalues the yuan from 6.5 to 6.3 per USD, it makes imports cheaper and strengthens the currency.

Managed Exchange Rates (Managed Float)

Definition: A managed exchange rate system, or managed float, allows the currency to float in the market but with periodic intervention by the government or central bank to influence its value. Unlike a fixed rate, it doesn’t commit to maintaining the rate at a precise level but instead aims to prevent excessive fluctuations.

Key Features:

• Market-Based with Intervention: The currency’s value is determined by the market forces of supply and demand, but central banks intervene occasionally to stabilize the exchange rate.
• Intervention Methods: Governments may buy/sell their currency, adjust interest rates, or use other monetary tools to influence the currency’s value.
• No Fixed Commitment: Unlike fixed systems, there is no commitment to maintain the currency at a set rate, allowing some flexibility.

Advantages of Managed Exchange Rates:

• Flexibility: Allows the currency to respond to market conditions while preventing extreme volatility.
• Policy Independence: Countries can pursue independent monetary policies suited to domestic conditions, unlike fixed rate systems.
• Controlled Speculation: Interventions can discourage excessive speculative movements against the currency.

Disadvantages of Managed Exchange Rates:

• Uncertainty: Some level of uncertainty remains for businesses due to potential government interventions.
• Resource Intensive: Frequent interventions require significant reserves and can be resource-intensive.
• Lack of Full Control: Although more flexible than a fixed rate, governments do not have full control over the currency value.

Consequences of Overvalued and Undervalued Currencies:

• Overvalued Currency:
  • Reduced Exports: Makes exports more expensive and less competitive internationally (e.g., the Swiss franc in the 2010s).
  • Increased Imports: Cheaper imports can hurt domestic industries, leading to trade deficits.
  • Potential Deflation: Prolonged overvaluation may lead to deflationary pressures.
• Undervalued Currency:
  • Boosts Exports: Makes exports cheaper and more competitive (e.g., accusations against China for keeping the yuan undervalued).
  • Expensive Imports: Raises the cost of imports, which can lead to inflation.
  • Trade Surpluses: Persistent undervaluation can lead to significant trade surpluses, potentially causing international tensions.

Real-World Examples

1. China’s Managed Float: The Chinese yuan operates under a managed float, where the People’s Bank of China intervenes to keep the yuan stable within a narrow range against a basket of currencies, primarily the US dollar.
2. Swiss Franc Cap: From 2011 to 2015, Switzerland set a cap on the franc at CHF 1.20 per euro to protect its export-reliant economy from deflation and economic downturn.
3. Argentina’s Fixed Exchange Rate (1991-2001): Argentina pegged its peso to the US dollar, leading to initial stability but ultimately ending in economic crisis due to the inability to respond flexibly to external economic shocks.

Glossary of Key Terms

• Devaluation: A deliberate reduction in the value of a currency in a fixed exchange rate system by the government.
• Fixed Exchange Rate: A system where the currency's value is pegged to another currency or basket of currencies and maintained through government intervention.
• Foreign Exchange Reserves: Assets held by a central bank in foreign currencies used to influence the exchange rate.
• Managed Float: A currency system that allows the exchange rate to be determined by the market but with occasional government intervention.
• Overvalued Currency: A situation where the currency value is higher than its market equilibrium, making exports expensive and imports cheap.
• Revaluation: A deliberate increase in the value of a currency in a fixed exchange rate system by the government.
• Undervalued Currency: A situation where the currency value is lower than its market equilibrium, making exports cheap and imports expensive.

Possible IB Economics Essay-Style Questions

1. Discuss the advantages and disadvantages of fixed exchange rate systems. Use real-world examples to support your arguments.
2. Evaluate the effectiveness of managed exchange rates in achieving macroeconomic stability. Include examples of countries that use managed floats.
3. Examine the impact of overvalued and undervalued currencies on a country’s economy. Use relevant data and examples to illustrate your points.
4. To what extent can fixed exchange rate systems be sustainable in the long term? Consider the role of foreign exchange reserves in your answer.

Recent Real-World Data and Examples

• Swiss Franc: After removing the cap in 2015, the Swiss franc appreciated rapidly against the euro, causing significant challenges for Swiss exporters.
• Chinese Yuan: As of 2024, China continues to manage the yuan’s value, keeping it relatively stable against a basket of major currencies while allowing gradual appreciation.
• Venezuelan Bolivar: An example of a currency with multiple exchange rates, illustrating the challenges of maintaining fixed rates amid hyperinflation.

Retrieval Questions for A-Level Students

1. What is the main difference between a fixed exchange rate and a managed exchange rate system?
2. Explain the concept of devaluation in a fixed exchange rate system.
3. Why might a country choose to maintain an overvalued currency? What are the potential risks?
4. How does a managed float differ from a free-floating exchange rate system?
5. Provide a real-world example of a country using a fixed exchange rate and discuss the challenges it faces.