How were floating exchange rates introduced?

Latin America Institute (LAI)

As part of a country's monetary policy, its respective exchange rate system is also determined or adjusted over time. A fundamental distinction is made between systems of flexible (“free”) and fixed (“fixed”) exchange rates. One can imagine that all exchange rate systems lie on an interval between completely fixed and completely flexible exchange rates. With completely fixed exchange rates, the government sets the exchange rate for one currency against another currency. With the completely flexible exchange rate, this is obtained through transactions on the foreign exchange markets. In addition to the money market and credit and capital markets, the foreign exchange market is part of the financial market in international trade.

How can governments set the exchange rate? To do this, the central bank of a country intervenes in the foreign exchange market. To understand the foreign exchange market, one can think of currencies as commodities. This means that currencies are not only used to carry out transactions, but that they also have other properties, such as being a means of holding wealth or being a means of speculation. On the capital markets, the exchange rate results from supply and demand in the exchange ratio of two currencies to one another. The exchange rate can be interpreted as the price of a currency and interpreted as market expectations. A rising exchange rate represents a demand that cannot be fully satisfied. A falling exchange rate stands for an offer that is not fully requested. The trade with foreign exchange in Germany takes place among other things on the Frankfurt stock exchange.

How do the different exchange rate systems work?

On the one hand, a central bank can fix the exchange rate and intervene in the foreign exchange markets if the exchange rate deviates from the target price. These interventions run as follows: If the currency appreciates, that is, the exchange rate drops in volume, then the central bank can sell domestic currency on the foreign exchange market. In Europe, for example, the European Central Bank could buy the currency it is interested in (US dollars, Swiss francs, etc.) with euros (which in turn is equivalent to selling euros). Because a larger amount of euros is now facing a smaller amount of other currencies on the foreign exchange market, the value of the euro falls, which means that it is devalued.

Why does this mechanism work? When the exchange rate drops in bulk quotation, this can be thought of as a euro shortage. One euro then “buys” more units of a foreign currency.

If a country has a free exchange rate, this means that the central bank does not intervene in the foreign exchange market, but the exchange rate is freely determined by supply and demand.

Forms of fixed exchange rate systems are:

  • the currency board, in German currency office. This is an institution that sets the exchange rate. In a currency board system, the currency reserves of the country introducing the currency board must be high enough that all banknotes in the domestic currency can be exchanged at any time for the currency with which the currency board exists - the domestic currency must therefore be exchanged for foreign ones Currency backed. In addition, the domestic currency must be exchangeable at any time into the foreign currency for which the currency board exists. Domestic monetary policy will be as good as abolished; In terms of monetary policy, the country is completely subordinate to the country to which the foreign currency of the currency board that has been set up belongs (usually the US dollar). For example, Argentina introduced a currency board for the US dollar in the early 1990s. Due to hyperinflation with more than 800% annual inflation, the Argentine government decided to introduce a currency board with a statutory 1: 1 pegging of the peso to the US dollar. The fight against inflation was quite successful, with the inflation rate falling to 300% in 1991 and below 100% in 1992. As early as 1994, the inflation rates in Argentina and the USA had converged. However, the fall in inflation in Argentina more than in the USA led to a real appreciation of the peso against the US dollar (see the formula for the real exchange rate). In addition, the US dollar appreciated against the euro. As a result of the peg to the US dollar, the peso also appreciated against the euro. In the course of the revaluations, Argentine products lost their price competitiveness on the world market because they became more expensive in real terms on the world market. Argentina therefore sold fewer exports, the current account deficit widened and was financed by capital imports. At the same time, international interest rates rose at the time, and with it Argentina's foreign debt. The scope of the central bank to keep the exchange rate at its level decreased. In 2002, Argentina abandoned the currency board system.1
  • the crawling peg, in German moving exchange rate parity. Here, the central bank announces in advance the percentage by which the exchange rate should depreciate in a certain period of time. The mechanism to bring about this change is an intervention as described above, but for a longer period of time and with small devaluating steps. For example, Brazil introduced a new currency, the real, in 1994 after a prolonged period of hyperinflation. This was initially tied to the US dollar at a certain parity (see fixed exchange rate). In 1995, after a strong real appreciation of the real, Brazil switched to a crawling peg system. The aim of this change was a real devaluation while at the same time controlling inflation.
  • Furthermore, the central bank can let the exchange rate fluctuate within a certain interval. In this case, the central bank allows the exchange rate to be determined according to supply and demand in the market; but only up to a certain fixed upper / lower limit. When these limits are reached, the central bank intervenes to keep the exchange rate within the specified "band" of upper and lower limits. This can be imagined as follows: the Brazilian central bank considers an exchange rate of 2 reals per US dollar to be a sensible exchange ratio. However, it considers fluctuations of ± 5% around this target value to be problem-free and allows trading with real (the central bank allows a "free" exchange rate in the range of 1.95 real / US $ to 2.05 real / US $). As soon as the real breaks the upper limit of 2.05 real / US $ or 1.95 real / US $ down, the central bank intervenes. If the limit is exceeded, the central bank will buy real against US dollar until the rate has stabilized again. If the limit falls below the limit, the central bank sells real or buys US dollars until the rate has stabilized again. This happened, for example, in the European Monetary System, the predecessor of the European Monetary Union, before the introduction of the euro. The aim was to align the national currencies of the euro zone in order to ensure the introduction of the common currency.

1 On the Argentina crisis and the currency board, see also: Fritz, Barbara (2002): Cry for Argentina; Dullien, Sebastian (2002): Argentina: The end of a clever idea? and Horn, Gustav and Ulrich Fritsche (2002): Argentina in Crisis