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A Seminar Term Paper On

FLOATING EXCHANGE RATES AND VARIOUS OTHER CONTEMPORARY EXCHANGE RATE ARRANGEMENTS

Submitted To Mr. Yogesh Satyal Course Instructor (International Business) Ace Institute of Management

Submitted By Anish Man Singh Basnyat Kamalesh Sthapit Prakash Koju Shradda Tiwari MBAe, Section B, Trim. IV, Spring 2013 Ace Institute of Management

Date of Submission: August 21, 2013

Floating exchange rates and various other contemporary exchange rate arrangements

1 Concept of Exchange Rate Exchange rate is the value of one currency compared to another. In other words, its an expression of national currencys quotation in respect to foreign ones. For example, if 1 Indian rupee is worth 1.6 Nepalese rupees, then the exchange rate of Indian currency is 1.6 Nepalese currencies. If something costs NRs. 160/-, then it automatically costs INR 100/- as a matter of accountancy. Thus, exchange rate is a conversion factor, a multiplier or a ratio depending on the direction of conversion. Types: Types of Exchange Rate One way of classifying the exchange rate is based upon rates established on a specific trade market- nominal exchange rates and real exchange rates. i. Nominal exchange rates are established on currency financial markets called "forex markets", which are similar to stock exchange markets. Central bank may also fix the nominal exchange rate. ii. Real exchange rates are nominal rate corrected somehow by inflation measures. For instance, if a country A has an inflation rate of 10%, country B an inflation of 5%, and no changes in the nominal exchange rate took place, then country A has now a currency whose real value is 10% - 5% = 5% higher than before. In fact, higher prices mean an appreciation of the real exchange rate, other things remaining same. Another classification of exchange rates is based on the number of currencies taken into account- Bilateral and Multilateral exchange rates. a. Bilateral exchange rates clearly relate to two countries' currencies. They are usually the results of matching of demand and supply on financial markets or in banking transaction. In this case of banking transaction, the central bank acts usually as one of the sides of the relationship. Other bilateral exchange rates may be simply computed from triangular relationships: if the exchange rate Dollar-NRs is 100 and the Dollar-Yen is 10,000 then, as a matter of computation, NRs 1 is worth 100 Yen. No

direct NRs-Yen transaction needs to take place. If, instead, a financial market exists for Nepalese Rupees to be exchanged with Yen, the expectation is that actions by speculators (arbitrage among markets) will bring the parity of 100 Yen per rupee as an effect. b. Multilateral exchange rates are computed in order to judge the general dynamics of a country's currency toward the rest of the world. One takes a basket of different currencies, select a (more or less) meaningful set of relative weights, then computes the "effective" exchange rate of that country's currency. For instance, having a basket made up of 40% US Dollars and 60% German Marks, a currency that suffered from a value loss of 10% in respect to Dollar and 40% to Mark will be said having faced an "effective" loss of 10%x0.4 + 40%x0.6 = 28%. Some countries impose the existence of more than one exchange rate, depending on the type and the subjects of the transaction. Multiple exchange rates then exist, usually referring to commercial vs. public transactions or consumption and investment imports. This situation requires always some degree of capital controls.

2 Exchange Rate Regimes An exchange-rate regime is the way an authority manages its currency in relation to other currencies and the foreign exchange market. A countrys exchange rate regime governs its exchange ratethat is, how much its own currency is worth in terms of the currencies of other countries. Lets have a scenario; A owner of a Pacific island surfboard shop, whether he knows it or not, thinking in March about the cost of buying 100 surfboards from his California supplier in July, should care about his countrys exchange rate regime. If the surfboard shop owners country has a fixed exchange rate regime, under which the value of the local currency is tied to that of the US Dollar, then he can be confident that the price of surfboards in his currency wont change over the coming months. By contrast, if his country has a flexible exchange rate regime vis--vis the US Dollar, then its currency could go up or down in value during the change of seasons and he may want to allocate more, or less, local currency for his forthcoming surfboard purchase. If we extend the above scenario to all cross-country transactions, we can see that the exchange rate regime has a big impact on world trade and financial flows. And the volume of transactions and the speed, at which they are growing, highlight the crucial role of the exchange rate in todays world, thereby making the exchange rate regime a central piece of any national economic policy framework. Types of Exchange Rate Regime The basically the exchange rate regimes are categorized into three types: Floating exchange rate, where the market dictates movements in the exchange rate; Pegged float, where a central bank keeps the rate from deviating around a target band or value; and Fixed exchange rate, which ties the currency to another currency, mostly more widespread currencies such as the U.S. dollar or the euro or a basket of currencies. (A) Floating Exchange Rate

When the exchange rate can freely move, assuming any value that demand and supply jointly establish, "freely floating exchange rate" will be the name of currency institutional regime. Equivalently, it is called "flexible" exchange rate as well. As the name implies, the floating exchange rate is mainly market determined.

In countries that allow their exchange rates to float, the central banks intervene (through purchases or sales of foreign currency in exchange for local currency) mostly to limit short-term exchange rate fluctuations. Therefor these regimes are often called managed float or dirty float. However, in a few countries (for example, New Zealand, Sweden, Iceland, the United States, and those in the euro area), the central banks almost never intervene to manage the exchange rates. Floating regimes offer countries the advantage of maintaining an independent monetary policy. In such countries, the foreign exchange and other financial markets must be deep enough to absorb shocks without large exchange rate changes. Also, financial instruments must be available to hedge the risks posed by a fluctuating exchange rate. Almost all advanced economies have floating regimes, as do most large emerging market countries.

Free float regime Managed float regime Different types of currency peg Usage of foreign currency
Source: http://en.wikipedia.org/wiki/File:Currency_Exchange_regimes.png

In "freely" and "managed" floating regimes, a loss in currency value is conventionally called depreciation, whereas an increase of currency's international value will be called "appreciation". If the dollar rises from NRs 80 to NRs 100, then it has shown an appreciation of 25%. Symmetrically, the NRs has undergone an 8% depreciation. Because of appreciation in exchange rate, the import price will fall and export price will rise. Similarly the impact of depreciation on business will result in rise of import price and fall of export price. But central banks can also declare a fixed exchange rate, offering to supply or buy any quantity of domestic or foreign currencies at that rate. In this case, one talks of a "fixed exchange rate". Under this regime, a loss of value, usually forced by market or a purposeful policy action, is called "devaluation", whereas an increase of international value is a "revaluation". (B) Pegged float (soft peg) exchange rate

Currencies that maintain a stable value against an anchor currency or a composite of currencies are called pegged float exchange rates. Pegged floating currencies are pegged to some band or value, either fixed or periodically adjusted. That is, the exchange rate can be pegged to the anchor within a narrow (+1 or 1 percent) or a wide (up to +30 or 30 percent) range, and, in some cases, the peg moves up or down over timeusually depending on differences in inflation rates across countries. So the pegged float exchange rate can be classified into i. Crawling bands: the rate is allowed to fluctuate in a band around a central value, which is adjusted periodically. This is done at a preannounced rate (normally within1%) or in a controlled way following economic indicators. ii. Crawling pegs: the rate itself is fixed, and adjusted as above. iii. Pegged with horizontal bands: the rate is allowed to fluctuate in a fixed band (bigger than 1%) around a central rate. Although soft pegs maintain a firm nominal anchor (that is, a nominal price or quantity that serves as a target for monetary policy) to settle inflation expectations, they allow for a limited degree of monetary policy

flexibility to deal with shocks. However, soft pegs can be vulnerable to financial criseswhich can lead to a large devaluation or even abandonment of the pegand this type of regime tends not to be long lasting. Costa Rica, Hungary, and China are examples of this type of peg. (C) Fixed (hard peg) floating rate Fixed rates are those that have direct convertibility towards another currency. These entail either the legally mandated use of another countrys currency (also known as full dollarization) or a legal mandate that requires the central bank to keep foreign assets at least equal to local currency in circulation and bank reserves (also known as a currency board). Hard pegs usually go hand in hand with sound fiscal and structural policies and low inflation. They tend to remain in place for a long time, thus providing a higher degree of certainty for pricing international transactions. However, the central bank in a country with a hard exchange rate peg has no independent monetary policy because it has no exchange rate to adjust. Panama, which has long used the US dollar, is an example of full dollarization, and Hong Kong SAR operates a currency board.

3 Analyses As floating exchange rates automatically adjust, they enable a country to reduce the impact of shocks and global business cycles, and to preempt the possibility of having a balance of payments crisis. However, they also engender unpredictability as the result of their dynamism. On the other hand, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. That may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency "strong" or "high" relative to others, such as the UK. The primary argument for a floating exchange rate is that it allows monetary policies to be useful for other purposes. Under fixed rates, monetary policy is committed to the single goal of maintaining exchange rate at its announced level. Yet the exchange rate is only one of the many macroeconomic variables that monetary policy can influence. A system of floating exchange rates leaves monetary policy makers free to pursue other goals such as stabilizing employment or prices. The debate of making a choice between fixed and floating exchange rate regimes is set forth by the MundellFleming model (Impossible Trinity), which argues that an economy (or the government) cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It must choose any two for control and leave the other to market forces.

Nepal

China

US

Nepal has been maintaining a pegged exchange rate to the Indian rupee for a long time. The peg of NRs1.60= IRs 1.0 has not been revised since 1993.

Conclusion/Recommendation: Whether the exchange rate system is floating, fixed or a combination of the two, there is no way that a country can insulate itself from external factors. It is an illusion to think that the floating rate system provides an escape route. This lack of insulation enforces interdependence. The more dominant an economy the more wide spread is the impact of its domestic economic policy on other countries. Therefore a satisfactory exchange rate system can emerge only if macro-economic policies of the major industrial countries are stable, mutually consistent and conducive to satisfactory performance of the world economy. Because the exchange rate regime is an important part of every countrys economic and monetary policy, policymakers need a common language for discussing exchange rate matters. After all, an exchange rate regime that looks soft to one observer may look hard to anotherwhich reflects, among other things, a lack of information among different players about foreign exchange markets and about purchases or sales of foreign exchange by central banks.

Sources:
http://economicswebinstitute.org/glossary/exchrate.htm Exchange Rate Regimes by Mark Stone, Harald Anderson, and Romain Veyrune (http://www.imf.org/external/pubs/ft/fandd/2008/03/pdf/basics.pdf) http://en.wikipedia.org/wiki/Floating_exchange_rate http://www.answers.com/topic/floating-exchange-rate

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