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The Foreign Exchange Rate Systems


There are several types of foreign exchange rate systems namely; floating exchange rate, pegged exchange rate and fixed exchange rate system. In a floating exchange rate system, the market movements determine the rate of exchange. The government or the central bank does not interfere with the rate of exchange. In pegged float system, the central bank controls the movement of exchange rate by ensuring that the rate does not deviate too much from the set value. In fixed exchange rate system, the governments fix the rate of exchange based on another currency. The common exchange rate today is the float exchange rate where central bank always intervenes to ensure there is no excessive depreciation or appreciation of the currency. This controlled float exchange rate is often referred to as ‘managed float’ since there is intervention of the central bank in managing exchange rate system. This paper explores why governments fixed exchange rates while private institutions prefer floating exchange rates. Moreover, the paper looks into the contribution of the Eurozone to the recent financial issues affecting Greece and Ireland.

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Exchange rate systems

Floating exchange rate

Private investors such as banks prefer floating exchange rate system instead of fixed exchange rate system for many reasons. The fluctuating exchange rate system leaves the value of the currency to change as the international exchange market changes. Floating exchange rate system adjusts automatically as the foreign exchange market changes. This adjustment will enable the country to reduce the effects of international business cycles and shocks and hence minimizing the possibility of crises in the country’s balance of payment. According to Mundell-flaming model, it is not possible for a country to have an exchange rate system that is fixed, whose monetary policy that is independent and free movement of capital simultaneously. Any economy can choose to control only two of these factors and allow market forces to control the third factor. Floating exchange rate system has a number of advantages to the investors, which include the following.

First, floating exchange rate system is very flexible and allows domestic financial system to adjust as the foreign exchange market changes. Hoffmann (2007) claims that flexible exchange rate may act as a shock absorber in the economy (p.425).For instance in 1973 there was the great oil crises which affected the economy of the world. Oil prices rose and there was depreciation of all the major global currencies. Floating exchange system both domestically and internationally helped to reduce the effect of this oil shock. Countries were able to adjust accordingly as the value of their currencies changes as the prices of oil rose. At such situation, fixed exchange rate would have great impact to both domestic and international economy thus affecting investors globally. Investors would like to operate under floating exchange rate system where the economy is adjusting as the external forces changes. Floating exchange rate system will reduce exchange rate risk among the investors since they will be able to adjust in any case of unexpected shock. Abbott and De Vita (2011) argue that economies with flexible exchange rate have shown higher economic growth compared with those using fixed rate (p.37). Fixed exchange system may also reduce the profit of the investors since they are not in a position to change their prices as the exchange rate changes. Economic instability that results as the economies using fixed exchange rate systems fails to adjust incase of external forces affect all the economic activities in the country thus exerting pressure to investors operating in that country. Thus, private investors prefer to operate in an economy that is adjusting as economic condition changes.

Secondly, a floating exchange rate requires low reserves for foreign exchange which has a low opportunity cost. A fixed exchange rate system holds large quantity of foreign currencies as a way of ensuring that there is enough currency to main fixed exchange rate system even when foreign exchange market changes. Floating exchange rate only holds a small quantity of foreign currencies in their reserves and avail the balance to the investors such as banks and other financial institutions to borrow for their private investment. Thirdly, a floating exchange rate allows automatic adjustment of balance of payment. For instance, in case of deficit in the balance of payment, the currency automatically depreciates as the imports exceed exports. This will make export of the country cheaper and imports expensive. This automatic adjustment will also allow investors to adjust accordingly and thus maintain their profitability.

Fixed exchange rate

On the other hand, governments prefer fixed exchange systems compared to floating exchange system for easier control of the foreign exchange rate. Fluctuating exchange rate system increases the volatility of foreign exchange. According Smirnov, (2010) there are many risks associated with flexible exchange rate (p.26).They may result into a serious financial problem and particularly to the emerging economies. This happens as emerging economies have either of the following conditions; financial fragility, effects of dollarization are high and strong effects of balance sheet. Many governments therefore are committed to ensure that the occurrences of these effects in the economy minimizes. It is the responsibility of the government to ensure that the financial system of the country is stable (Guisinger & Singer 2010, p.313). Though floating exchange rate system has many advantages as we have seen above, it has many threats to the stability of the financial systems and hence the stability of the economy. When assets are denominated in local currency and liabilities in other foreign currencies, any unexpected change in the exchange rate such as depreciation will affect corporate and bank balance sheets thus shaking the stability of the local financial system. These effects are even worse in the emerging countries where a small variation in the exchange rate will results to greater impacts on the interest rates and movements of the reserve. Thus many national governments react to these behaviors of floating exchange rate by coming up with monetary policy that ensure that exchange rate are in control.

Another reason why governments prefer fixed exchange rate system is the ability to reduce risk that occurs in the international trade. When a country maintains an exchange rate that is fixed, traders in the international market are in a position to fix prices for their goods and services without being troubled of any unexpected change in the prices of goods and services due to change in foreign exchange rate. As Broz, Frieden and Weymouth (2008) argue, investors would like to operate in a stable economy (p.417). Fixed exchange system enable traders to carry out their transactions without altering their terms of contract that may arise due to fluctuation in foreign exchange rate. Fixed exchange rate ensures that there is certainty in business transactions thus promoting investment in international market. Fixed exchange rate system also ensures that there is discipline in the management of the economy. National governments have come up with inflationary policies to reduce disequilibrium of the domestic economy as foreign exchange market changes. These inflationary policies will also ensure problems of balance of payments and unemployment reduce. Furthermore, inflationary policies will ensure that domestic economy remain competitive in the global market. Fixed exchange rate system will also ensure elimination of destabilizing speculation in the economy. Speculation flows reduce significantly as fixed exchange rate keep speculation incentives as low as possible.

Greece and Ireland financial crises

The recent financial crises in some of the European countries such as Ireland, Greece, Portugal and Spain are threatening existence of euro currency and European Union (Economic Outlook 2009, p.14). One of the major causes of these crises is the creation of Eurozone, which all the four countries are members. These countries should take bail out as a way of restoring their financial stability and ensure that these crises do not spread to other European Union countries. However, countries like Ireland are not willing to take bail out despite the pressure from the European Union to do so. Greece is the worst affected by this crises with a deficit of 15.4 percent of GDP in 2009.

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Both Greece and Ireland are members of Eurozone, which is a monetary, and economic union made up of seventeen members of the European Union. Eurozone has adopted a common currency (euro) which the member states used as the only legal tender. Eurozone through European currency board set the interest rates for the member states and try to maintain fixed interest rates. Eurozone has also tried to coordinate and harmonize fiscal policies in all the seventeen member states to ensure a stable economic zone. Member states should respect a Pact for growth and stability to ensure the common currency is stable. This pact also set the limit for national debt and deficit for all the member countries. Sanctions exist for those member states who does not abide with these limits for national debt and deficit. Initially, the Eurozone had set a limit of deficit of three percent of the GDP but 2005 some reforms came into play to allow for flexibility to the economic conditions. However, the Eurozone does not allow for monetary and fiscal policy ease, which has made several countries in European to be reluctant in joining the zone. Failure to allow for monetary and fiscal policy ease has affected economic stability of the member states since they are not in a position to undertake policies that are in line with their prevailing domestic economic conditions. Absurd structure of Eurozone has affected the economy of member states negatively (Parguez, 2010, p.31).Harmonization of the monetary and fiscal policies like areas of budgetary and taxation policy can be termed as overriding the sovereignty of the member states concerning their domestic economy. For instance, Greece, Ireland, and other member states facing financial crises are limited to undertake domestic fiscal and monetary policies, which may help them to come out of these crises.

Member states of the Eurozone who breach the set limit of deficit faces sanction as provided by the stability and growth pact. Member states are also required to present their national budget in the Eurozone council before presenting it in their national parliaments. If the deficit in the budget of a given member state is so high then it faces more scrutiny to align it with the requirements of the Euro Zone. These requirements have seriously affected the economy of poor states such as Greece, which cannot operate comfortably without having some deficit in their budget. When such countries raises their rate of inflation and interest rates, they risk facing sanctions such as suspending regional funding as well as their voting rights in the Eurozone council.

Before 2007, Greece economy was growing at a very fast rate with annual growth rate of 4.2 percent. Foreign capital was flooding in the country especially from the members of the European Union, which made government to carry out most of its transaction in form of euro currency rather than domestic currency. Prevailing strong economy allowed the Greece government to operate with large deficit, which based on the euro currency rather than domestic currency. When 2008 global financial crises started, the country could not maintain the large deficit and therefore started to fall economically. Because the country was a member of the Eurozone, it could not use monetary policies to stabilize the economy. This also applies for in the case of Ireland, which may not be a position to use monetary policy to manipulate its economy as a way of dealing with large deficit in the economy. If these two countries were not member state of the Eurozone, they could have come up with monetary policy such as printing of new money to stimulate the economy back to stability (Herwartz & Roestel 2009, p.1). For instance in order for the US to deal with global financial crises in 2008, the Federal Reserve’s balance sheet expanded to $ 1.3 trillion through printing of new money and buying of the outstanding debt. This has helped the country to recover from the financial crises. Greece, Ireland and other European nations experiencing financial crises would have taken similar measures or other monetary policy to restore the stability of their economies.

These economies are only limited to use euro currency in their foreign trade rather than to use domestic currency. As Bird (2010) indicates, financial crises in these countries is a result of mechanism of exchange rate imposed by the Eurozone regulations (p.41).Since large proportion of their GDP comprises of foreign trade, the use of domestic currency is then limited only to the local trade. If these countries use domestic currency more than euro currency, it could be easier for the national governments to come up with monetary policies to stimulate their economies. However, it is not possible for government to make monetary policy to regulate the use of euro currency since it is a regional currency and there are rules that limit manipulation of the currency by national governments. Wihlborg, Willett and Nan (2010) claim that lack of internal adjustment mechanism in Greece and other European countries has contributed greatly to the current financial crises (p.51). These limitations have therefore limited the capacities of these governments to deal with the current financial crises.


For any economy to grow there is need to strike a balance between floating exchange rate and fixed exchange rate system. These two types of exchange rate have their advantages and disadvantages which any government should seek to optimize. The following recommendations address this issues as well as financial crises facing Greek, Ireland and other European countries.

  • National government should allow floating exchange rate to enable the value of currency to adjust as the foreign exchange market changes. However, the government through central bank should intervene when necessary to control volatility of the exchange rate.
  • Government should maintain quantity of reserve that is not too high neither too low to ensure that there is no large quantity of money lying idle in the economy.
  • . To prevent the occurrence of financial crisis, the government should maintain discipline in the management of the economy.
  • Greece and Ireland together with other member states of the Eurozone should have some autonomy to use the domestic currencies in their foreign trade as a way of stabilizing their financial systems.
  • The rule that sets limits for national debt and deficit in the Eurozone should put into considerations economic differences among the member states.

A floating exchange rate system with some control by the government through central bank may be the best type of exchange rate. Investors would like to operate under floating exchange rate where the rate is changing according to market forces. However, for the government to stimulate economic growth, it is necessary to control partially the exchange rate. Current global crises facing Greece and Ireland are due to absurd structure used by Eurozone, which limit member states to adjust their domestic economies using fiscal and monetary policies as the global economy changes. The recommendations provided in this research can address this problem.

Reference List

Abbott, A., & De Vita, G., 2011. Revisiting the Relationship between Inflation and Growth: A Note on the Role of Exchange Rate Regimes. Economic Issues, 16(1), pp.37-52.

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Bird, G., 2010. The Eurozone: What Now? World Economics journal, 11(3), pp.41-59.

Broz, J., Frieden, J., & Weymouth, S., 2008. Exchange Rate Policy Attitudes: Direct Evidence from Survey Data. MF Staff Papers, 55(3), pp.417-444.

Economic Outlook, 2009. Financial crisis puts strains on Eurozone unity, 33 (2), pp.14-23.

Guisinger, A., & Singer, D., 2010. Exchange Rate Proclamations and Inflation-Fighting Credibility. International Organization, 64(2), pp.313-337.

Herwartz, H., & Roestel, J., 2009. Monetary Independence under Floating Exchange Rates: Evidence Based on International Breakeven Inflation Rates. Studies in Nonlinear Dynamics & Econometrics, 13(4), pp.1-23.

Hoffmann, M., 2007. Fixed Versus Flexible Exchange Rates: Evidence from Developing Countries. Economical journal, 74(295), pp.425-449.

Parguez, A., 2010. Lies and Truth about the Financial Crisis in the Eurozone. International Journal of Political Economy, 39(4), pp.31-55.

Smirnov, S., 2010. The Exchange Rate Regime and Economic Stability. Problems of Economic Transition, 53(3), pp.26-44.

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Wihlborg, T., & Nan, Z., 2010. The Euro Debt Crisis. World Economics, 11(4), pp.51-77.

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