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Lesson M10.L04: Exchange Rate Regimes — Fixed, Floating, and Managed

Module: Exchange Rates and the Open Economy Level: intro Duration: 30 minutes Learning Objective: Compare the costs and benefits of fixed versus floating exchange rate regimes. Data as of: 2024 Provenance: OpenStax Macro 3e | MIT OCW 14.02 | RBA Education

Explanation

Countries choose how to manage their currency — the exchange rate regime. There are three main options:

1. Fixed (pegged) exchange rate: The central bank commits to maintaining a specific exchange rate against another currency (or basket). To defend the peg, it must buy or sell its own currency in FX markets, and subordinate interest rate policy to the exchange rate target. - Examples: Hong Kong's peg to USD (since 1983); China's managed peg to a basket; many Gulf states pegged to USD. - Benefits: Price certainty for trade and contracts; reduces exchange rate risk; can anchor inflation expectations (especially useful for small, open economies). - Costs: Loss of monetary policy independence; requires large foreign exchange reserves; vulnerable to speculative attacks if the peg loses credibility.

2. Floating exchange rate: The exchange rate is determined entirely by market supply and demand. The central bank does not target any particular rate. - Examples: Australia (since 1983), US, UK, eurozone (as a whole), Japan. - Benefits: Monetary policy independence (can target inflation or unemployment); automatic stabiliser — commodity booms appreciate the currency, restraining inflation; no need for large reserves. - Costs: Exchange rate volatility creates uncertainty for exporters, importers, and investors; may amplify global financial shocks.

3. Managed float (dirty float): The exchange rate is mostly market-determined but the central bank intervenes to smooth excessive volatility or resist misalignment. - Examples: Singapore (managed against a basket with an undisclosed band); China (officially a managed float); India.

The impossible trinity (Mundell-Fleming trilemma) states a country cannot simultaneously have: (i) a fixed exchange rate, (ii) free capital flows, and (iii) independent monetary policy. It can have at most two of the three. Australia chose (ii) and (iii) — free capital and independent monetary policy — requiring a floating exchange rate.

Worked Example

Scenario: Defending a fixed exchange rate — the cost in reserves

Suppose a small economy pegs its currency at 1 NatCoin = US$1.00 and faces a speculative attack: markets sell NatCoin, pushing it toward 0.92. The central bank must buy NatCoin (sell USD reserves) to defend the peg.

Given: - Speculative pressure: $5 billion worth of NatCoin sold in markets over 3 days - Central bank's total foreign reserves: $12 billion - Defence requires buying $5 billion of NatCoin

Step 1 — Calculate reserves after defence:

Reserves after = 12 − 5 = $7 billion

Step 2 — Calculate reserves lost as % of total:

% lost = (5/12) × 100 = 41.7% of reserves depleted in 3 days

Step 3 — Assess sustainability:

If speculative selling continues at the same rate:

Days until reserves exhausted = 12 / (5/3) = 12 / 1.667 = 7.2 days

The peg would collapse within a week if selling continued — illustrating why pegs are vulnerable to attacks.

Step 4 — Interest rate alternative:

The central bank could instead raise interest rates sharply to attract capital inflows and defend the peg:

If raising i by 5% attracts $3b in capital inflows, reserve drain reduces to $2b/3 days → 18 days of reserves remaining.

But the 5% rate hike would crush domestic investment and consumption — the economic cost of defending the peg.

Conclusion: Defending a peg is costly in either reserves or domestic economic activity, illustrating why many countries ultimately abandon pegs under pressure.

Common Misconception

Misconception: "A floating exchange rate is always better than a fixed rate — that's why Australia floated in 1983."

Correction: The optimal exchange rate regime depends on a country's characteristics. Small, open economies highly integrated with one trading partner may benefit from fixing (e.g., Panama uses the USD). The key costs of floating are exchange rate volatility and uncertainty — serious concerns for small exporters. Australia benefited from floating because of its commodity exposure (the exchange rate acts as a natural shock absorber) and its desire for independent monetary policy. But for countries with a history of monetary instability, pegging to a credible anchor currency can reduce inflation and borrowing costs — benefits that may outweigh the loss of monetary independence.

Practice Prompts

  1. State the impossible trinity and explain which two of the three elements Australia has chosen, and what this requires. → Answer: The impossible trinity states a country cannot simultaneously have: (i) a fixed exchange rate, (ii) free capital mobility, and (iii) independent monetary policy. Australia chose (ii) free capital flows and (iii) independent monetary policy (the RBA sets the cash rate to target 2–3% inflation). This requires giving up (i) — hence Australia operates a floating exchange rate since 1983. The float is the price Australia pays for having a fully open capital account and an independent central bank.

  2. NUMERICAL CALCULATION: A country has foreign reserves of US$20 billion and is defending a fixed exchange rate peg. Speculators sell the domestic currency at a rate of US$3 billion per day. The central bank also raises interest rates, attracting US$1 billion per day in capital inflows. (a) What is the net daily reserve drain? (b) How many days can the peg survive? → Answer: (a) Net drain = outflow − inflow = 3 − 1 = US$2 billion per day (b) Days until reserves exhausted = 20 / 2 = 10 days The peg can survive for only 10 days at this rate of drain — demonstrating the vulnerability of fixed exchange rates to sustained speculative attacks.

  3. Singapore operates a "managed float" where the Monetary Authority of Singapore (MAS) targets an undisclosed exchange rate band against a trade-weighted basket. Why might this regime suit Singapore better than a fully free float like Australia's? → Answer: Singapore is a very small, highly open economy where trade is roughly 3× GDP — exchange rate stability is crucial for business planning and inflation control (most goods are imported). A fully free float would expose Singapore to excessive volatility driven by global capital flows unrelated to its fundamentals. The managed float gives Singapore the benefits of pegging (stability, inflation anchor) while retaining some flexibility to adjust the band when fundamentals change — avoiding the rigidity that makes pure pegs vulnerable to speculative attacks. It also allows Singapore to use the exchange rate (rather than interest rates) as the primary monetary policy tool, which suits an economy with a fully open capital account and limited scope for domestic interest rate management.

Further Resources