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The Euro
To fix or to float - what determines the exchange rate?
There are various possible exchange rate regimes. At the two extremes are fixed rates and floating rates. In between the two extremes are a variety of possibilities including adjustable peg systems (like the ERM) and managed or dirty floats where the government intervenes to try to influence the value of the exchange rate.
Fixed exchange rates: A fixed exchange rate system is one where the value of the currency against other currencies remains exactly the same. It is set at a certain level either against another currency or against a commodity like gold. The UK lived under a fixed exchange rate system from 1944 (after the Bretton Woods conference) until 1972 when the system of fixed exchange rates broke down.
However, a fixed exchange rate doesn't stay fixed on its own. Governments have to hold large stocks of foreign exchange, so that they can actively intervene to hold the value of the currency stable. Monetary and fiscal policies will also have to be directed to keeping the rate constant.
Floating exchange rates: A floating exchange rate is an exchange rate that is determined by buyers and sellers without government intervention. A floating exchange rate system is where the external value of the currency is allowed to find its own value against other currencies. The value will be determined by supply and demand in the foreign exchange market. The value will then rise or fall according to changes in supply and demand. This equilibrium is shown in the supply and demand diagram below:
Dirty (managed) float: A managed float is a situation where the government intervenes to try to influence the level of the exchange rate. If they want to try to raise the exchange rate or prevent it from falling further they may intervene by selling foreign exchange and buying sterling. This will raise the demand for sterling and help support the value of the exchange rate. The diagram below shows this situation:
If the government want to intervene to prevent the exchange rate falling further then they will have to buy all sterling offered at the rate they want to maintain. This is shown by D2 where the demand curve becomes perfectly elastic at that rate. This is because the government will buy any sterling offered. A shift in supply from S1 to S2 will therefore only allow the exchange rate to fall to $1.68 rather then the $1.67 that would be the case without intervention.
Exchange rate mechanism: The ERM worked by setting a central value for the exchange rate and allowing it to fluctuate by a fixed percentage either side of that central value. The initial fixed value for sterling for set at DM2.95 and the value was allowed to fluctuate 6% either side of that value. For other countries the bands were narrower, but the UK had joined more recently. If sterling approached the upper or lower limit then the government would intervene either by buying and selling sterling or foreign exchange or by changing the level of interest rates. An increase in interest rates would help raise the demand for sterling and vice versa.