A floating currency is a currency that uses a floating exchange rate as its exchange rate regime. A floating currency is contrasted with a fixed currency.
In the modern world, the majority of the world's currencies are officially but not really floatingincluding the most widely traded currencies: the United States dollar, the Japanese yen, the euro, the British pound and the Australian dollar. The Canadian dollar most closely resembles the ideal floating currency as that their central bank has not interfered with its price since it officially stopped doing so in 1998.
The United States is a close second with very little changes in its foreign reserves; by contrast, Japan and the UK continually interfere with the prices of their respective currencies. From 1946 to the early 1970s, the Bretton Woods system made fixed currencies the norm; however, in 1971, the United States government abandoned the gold standard, so that the US dollar was no longer a fixed currency, and most of the world's currencies followed suit.
A floating currency is one where targets other than the exchange rate itself are used to administer monetary policy.
The People's Republic of China recently unpegged their currency, which was formerly pegged to the US dollar, and allowed it to float within a carefully managed range of values relative to the dollar and other currencies.
Wednesday, February 25, 2009
Floating exchange rates
A floating exchange rate or a flexible exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. The opposite of a floating exchange rate is a fixed exchange rate.
There are economists who think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to: dampen the impact of shocks & foreign business cycles; and preempt the possibility of having a balance of payments crisis. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty.
This 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 or the Southeast Asia countries before the Asian currency crisis. The debate of making a choice between fixed and floating exchange rate regimes is set forth by Mundell-Fleming model understood, which argues that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It can choose any two for control, and leave third to the market forces.
In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by the central bank may take the form of buying or selling large lots in order to provide price support or resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds.
There are economists who think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to: dampen the impact of shocks & foreign business cycles; and preempt the possibility of having a balance of payments crisis. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty.
This 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 or the Southeast Asia countries before the Asian currency crisis. The debate of making a choice between fixed and floating exchange rate regimes is set forth by Mundell-Fleming model understood, which argues that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It can choose any two for control, and leave third to the market forces.
In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by the central bank may take the form of buying or selling large lots in order to provide price support or resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds.
Devaluation
Devaluation is a reduction in the value of a currency with respect to other monetary units. In common modern usage, it specifically implies an official lowering of the value of a country's currency within a fixed exchange rate system, by which the monetary authority formally sets a new fixed rate with respect to a foreign reference currency. In contrast, (currency) depreciation is used for the unofficial decrease in the exchange rate in a floating exchange rate system. The opposite of devaluation is called revaluation.
Depreciation and devaluation are sometimes incorrectly used interchangeably, but they always refer to values in terms of other currencies. Inflation, on the other hand, refers to the value of the currency in goods and services (related to its purchasing power). Altering the face value of a currency without reducing its exchange rate is a redenomination, not a devaluation or revaluation.
Depreciation and devaluation are sometimes incorrectly used interchangeably, but they always refer to values in terms of other currencies. Inflation, on the other hand, refers to the value of the currency in goods and services (related to its purchasing power). Altering the face value of a currency without reducing its exchange rate is a redenomination, not a devaluation or revaluation.
Gold Standard
The gold standard is a monetary system in which a region's common media of exchange are paper notes that are normally freely convertible into pre-set, fixed quantities of gold. The standard specifies how the gold backing would be implemented, including the amount of specie per currency unit.
The currency itself has no innate value, but is accepted by traders because it can be redeemed for the equivalent specie. A U.S. silver certificate, for example, could be redeemed for an actual piece of silver.
Gold was a common form of representative money due to its rarity, durability, divisibility, fungibility, and ease of identification.
Representative money and the gold standard were used to protect citizens from hyperinflation and other abuses of monetary policy, as were seen in some countries during the Great Depression. However, they were not without their problems and critics, and so were partially abandoned via the international adoption of the Bretton Woods System.
Under this system all other major currencies were tied at fixed rates to the dollar, which itself was tied to gold at the rate of $35 per ounce. That system eventually collapsed in 1971, which caused most countries to switch to fiat money, backed only by the laws of the country. Austrian economists strongly favor a return to a 100 percent gold standard.
Under a gold standard, the long term rate of inflation (or deflation) would be determined by the growth rate of the supply of gold relative to total output. Critics argue that this will cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be determined by gold mining, which some believe contributed to the Great Depression
The currency itself has no innate value, but is accepted by traders because it can be redeemed for the equivalent specie. A U.S. silver certificate, for example, could be redeemed for an actual piece of silver.
Gold was a common form of representative money due to its rarity, durability, divisibility, fungibility, and ease of identification.
Representative money and the gold standard were used to protect citizens from hyperinflation and other abuses of monetary policy, as were seen in some countries during the Great Depression. However, they were not without their problems and critics, and so were partially abandoned via the international adoption of the Bretton Woods System.
Under this system all other major currencies were tied at fixed rates to the dollar, which itself was tied to gold at the rate of $35 per ounce. That system eventually collapsed in 1971, which caused most countries to switch to fiat money, backed only by the laws of the country. Austrian economists strongly favor a return to a 100 percent gold standard.
Under a gold standard, the long term rate of inflation (or deflation) would be determined by the growth rate of the supply of gold relative to total output. Critics argue that this will cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be determined by gold mining, which some believe contributed to the Great Depression
Fixed Exchange rate
Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.
Monetary Policies
Today the primary tool for controlling inflation is monetary policy. Most central banks are tasked with keeping the federal funds lending rate at a low level, normally to a target rate around 2% to 3% per annum, and within a targeted low inflation range, somewhere from about 2% to 6% per annum.
There are a number of methods that have been suggested to control inflation. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches.
For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied.
Monetarists emphasize increasing interest rates (slowing the rise in the money supply, monetary policy) to fight inflation. Keynesians emphasize reducing demand in general, often through fiscal policy, using increased taxation or reduced government spending to reduce demand as well as by using monetary policy.
Supply-side economists advocate fighting inflation by fixing the exchange rate between the currency and some reference currency such as gold. This would be a return to the gold standard. All of these policies are achieved in practice through a process of open market operations.
There are a number of methods that have been suggested to control inflation. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches.
For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied.
Monetarists emphasize increasing interest rates (slowing the rise in the money supply, monetary policy) to fight inflation. Keynesians emphasize reducing demand in general, often through fiscal policy, using increased taxation or reduced government spending to reduce demand as well as by using monetary policy.
Supply-side economists advocate fighting inflation by fixing the exchange rate between the currency and some reference currency such as gold. This would be a return to the gold standard. All of these policies are achieved in practice through a process of open market operations.
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. The term "inflation" once referred to increases in the money supply, however, economic debates about the relationship between money supply and price levels have led to its primary use today in describing price inflation.
Inflation can also be described as a decline in the real value of money—a loss of purchasing power in the medium of exchange which is also the monetary unit of account.
When the general price level rises, each unit of currency buys fewer goods and services. A chief measure of price inflation is the inflation rate, which is the percentage change in a price index over time.
Inflation can cause adverse effects on the economy. For example, uncertainty about future inflation may discourage investment and saving. High inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future.
Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply.
Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth.
Today, most economists favor a low steady rate of inflation.
Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reducing the risk that a liquidity trap prevents monetary policy from stabilizing the economy.
The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.
Inflation can also be described as a decline in the real value of money—a loss of purchasing power in the medium of exchange which is also the monetary unit of account.
When the general price level rises, each unit of currency buys fewer goods and services. A chief measure of price inflation is the inflation rate, which is the percentage change in a price index over time.
Inflation can cause adverse effects on the economy. For example, uncertainty about future inflation may discourage investment and saving. High inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future.
Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply.
Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth.
Today, most economists favor a low steady rate of inflation.
Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reducing the risk that a liquidity trap prevents monetary policy from stabilizing the economy.
The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.
Real Interest rate
The "real interest rate" is approximately the nominal interest rate minus the inflation rate. Since the inflation rate over the course of a loan is not known initially, volatility in inflation represents a risk to both the lender and the borrower.
Risk
In economics and finance, an individual who lends money for repayment at a later point in time expects to be compensated for the time value of money, or not having the use of that money while it is lent. In addition, they will want to be compensated for the risks of having less purchasing power when the loan is repaid.
These risks are systematic risks, regulatory risks and inflation risks. The first includes the possibility that the borrower will default or be unable to pay on the originally agreed upon terms, or that collateral backing the loan will prove to be less valuable than estimated. The second includes taxation and changes in the law which would prevent the lender from collecting on a loan or having to pay more in taxes on the amount repaid than originally estimated.
The third takes into account that the money repaid may not have as much buying power from the perspective of the lender as the money originally lent, that is inflation, and may include fluctuations in the value of the currencies involved.
Nominal interest rate
Nominal interest rates include all three risk factors, plus the time value of the money itself. Real interest rates include only the systematic and regulatory risks and are meant to measure the time value of money. Real rates = Nominal rates minus Inflation and Currency adjustment. The "real interest rate" in an economy is often the rate of return on a risk free investment, such as US Treasury notes, minus an index of inflation, such as the CPI, or GDP deflator.
Risk
In economics and finance, an individual who lends money for repayment at a later point in time expects to be compensated for the time value of money, or not having the use of that money while it is lent. In addition, they will want to be compensated for the risks of having less purchasing power when the loan is repaid.
These risks are systematic risks, regulatory risks and inflation risks. The first includes the possibility that the borrower will default or be unable to pay on the originally agreed upon terms, or that collateral backing the loan will prove to be less valuable than estimated. The second includes taxation and changes in the law which would prevent the lender from collecting on a loan or having to pay more in taxes on the amount repaid than originally estimated.
The third takes into account that the money repaid may not have as much buying power from the perspective of the lender as the money originally lent, that is inflation, and may include fluctuations in the value of the currencies involved.
Nominal interest rate
Nominal interest rates include all three risk factors, plus the time value of the money itself. Real interest rates include only the systematic and regulatory risks and are meant to measure the time value of money. Real rates = Nominal rates minus Inflation and Currency adjustment. The "real interest rate" in an economy is often the rate of return on a risk free investment, such as US Treasury notes, minus an index of inflation, such as the CPI, or GDP deflator.
Interest rates
An interest rate is the price a borrower pays for the use of money they do not own, for instance a small company might borrow from a bank to kick start their business, and the return a lender receives for deferring the use of funds, by lending it to the borrower. Interest rates are normally expressed as a percentage rate over the period of one year.
Interest rates targets are also a vital tool of monetary policy and are used to control variables like investment, inflation, and unemployment.
Interest rates throughout history have been variously set either by national governments or central banks. For example, the Federal Reserve federal funds rate in the United States has varied between about 0.25% to 19% from 1954 to 2008, while the Bank of England base rate varied between 15% and 1% from 1989 to 2009, and Germany experienced rates close to 90% in the 1920s down to about 2% in the 2000s. During an attempt to tackle spiralling hyperinflation in 2007, the Central Bank of Zimbabwe increased interest rates for borrowing to 800%.
Deferred consumption. When money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate.
Inflationary expectations. Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this.
Alternative investments. The lender has a choice between using his money in different investments. If she chooses one, she forgoes the returns from all the others. Different investments effectively compete for funds.
Risks of investment. There is always a risk that the borrower will go bankrupt, abscond, or otherwise default on the loan.
This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.
Liquidity preference. People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realise.
Taxes. Because some of the gains from interest may be subject to taxes, the lender may insist on a higher rate to make up for this loss.
The nominal interest rate is the amount, in money terms, of interest payable.
For example, suppose a household deposits $100 with a bank for 1 year and they receive interest of $10. At the end of the year their balance is $110. In this case, the nominal interest rate is 10% per annum.
The real interest rate, which measures the purchasing power of interest receipts, is calculated by adjusting the nominal rate charged to take inflation into account.
If inflation in the economy has been 10% in the year, then the $110 in the account at the end of the year buys the same amount as the $100 did a year ago. The real interest rate, in this case, is zero.
Interest rates targets are also a vital tool of monetary policy and are used to control variables like investment, inflation, and unemployment.
Interest rates throughout history have been variously set either by national governments or central banks. For example, the Federal Reserve federal funds rate in the United States has varied between about 0.25% to 19% from 1954 to 2008, while the Bank of England base rate varied between 15% and 1% from 1989 to 2009, and Germany experienced rates close to 90% in the 1920s down to about 2% in the 2000s. During an attempt to tackle spiralling hyperinflation in 2007, the Central Bank of Zimbabwe increased interest rates for borrowing to 800%.
Deferred consumption. When money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate.
Inflationary expectations. Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this.
Alternative investments. The lender has a choice between using his money in different investments. If she chooses one, she forgoes the returns from all the others. Different investments effectively compete for funds.
Risks of investment. There is always a risk that the borrower will go bankrupt, abscond, or otherwise default on the loan.
This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.
Liquidity preference. People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realise.
Taxes. Because some of the gains from interest may be subject to taxes, the lender may insist on a higher rate to make up for this loss.
The nominal interest rate is the amount, in money terms, of interest payable.
For example, suppose a household deposits $100 with a bank for 1 year and they receive interest of $10. At the end of the year their balance is $110. In this case, the nominal interest rate is 10% per annum.
The real interest rate, which measures the purchasing power of interest receipts, is calculated by adjusting the nominal rate charged to take inflation into account.
If inflation in the economy has been 10% in the year, then the $110 in the account at the end of the year buys the same amount as the $100 did a year ago. The real interest rate, in this case, is zero.
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