Economics

What are the advantages and disadvantages of both a fixed exchange rate regime and a flexible exchange rate regime?

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2008-09-08 20:09:13

There are two ways the price of a currency can be determined

against another. A fixed, or pegged, rate is a rate the government

(central bank) sets and maintains as the official exchange rate. A

set price will be determined against a major world currency

(usually the U.S. dollar, but also other major currencies such as

the euro, the yen, or a basket of currencies). In order to maintain

the local exchange rate, the central bank buys and sells its own

currency on the foreign exchange market in return for the currency

to which it is pegged.

If, for example, it is determined that the value of a single

unit of local currency is equal to USD 3.00, the central bank will

have to ensure that it can supply the market with those dollars. In

order to maintain the rate, the central bank must keep a high level

of foreign reserves. This is a reserved amount of foreign currency

held by the central bank which it can use to release (or absorb)

extra funds into (or out of) the market. This ensures an

appropriate money supply, appropriate fluctuations in the market

(inflation/deflation), and ultimately, the exchange rate. The

central bank can also adjust the official exchange rate when

necessary.

Floating

Unlike the fixed rate, a floating exchange rate is determined by

the private market through supply and demand. A floating rate is

often termed "self-correcting", as any differences in supply and

demand will automatically be corrected in the market. Take a look

at this simplified model: if demand for a currency is low, its

value will decrease, thus making imported goods more expensive and

thus stimulating demand for local goods and services. This in turn

will generate more jobs, and hence an auto-correction would occur

in the market. A floating exchange rate is constantly changing.

In reality, no currency is wholly fixed or floating. In a fixed

regime, market pressures can also influence changes in the exchange

rate. Sometimes, when a local currency does reflect its true value

against its pegged currency, a "black market" which is more

reflective of actual supply and demand may develop. A central bank

will often then be forced to revalue or devalue the official rate

so that the rate is in line with the unofficial one, thereby

halting the activity of the black market.

In a floating regime, the central bank may also intervene when

it is necessary to ensure stability and to avoid inflation;

however, it is less often that the central bank of a floating

regime will interfere.

Fixed vs. Flexible

Fixed advantages A fixed

exchange rate should reduce uncertainties for all economic agents

in the country. As businesses have the perfect knowledge that the

price is fixed and therefore not going to change they can plan

ahead in their productions. Inflation may have a harmful effect on

the demand for exports and imports. To ensure that inflation is

kept as low as possible the government is forced to take

measurements, to keep businesses competitive in foreign markets. In

theory a fixed exchange rate should also reduce speculations in

foreign exchange markets. In reality this is not always the case as

countries want to make speculative gains.

Fixed Disadvantages The government is keeping the

exchange rate fixed by manipulating the interest rates. If the

exchange is in danger of falling the government needs to increase

interest rates to increase demand for the currency. As this would

have a deflationary effect on the economy the demand might decrease

and unemployment might increase. A government has to maintain high

levels of foreign reserves to keep the exchange rate fixed as well

as to instill confidence on the foreign exchange markets. This

makes clear that a country is able to defend its currency by the

buying and selling of foreign currencies. Fixing the exchange rate

is not easy as there are many variables which are changing over

time if the exchange rate is set wrong it might be hard for export

companies to be competitive in foreign countries. International

disagreement might be created when a country sets its exchange rate

on a too low level. This would make a countries export more

competitive which might lead to a disagreement between countries as

they might see it as an unfair trade advantage.

Flexible Advantages As the exchange rate does not have to

be kept at a certain level anymore interest rates are free to be

employed as domestic management policies(Appleyard 703). The

floating exchange rate is adjusting itself to keep the current

account balanced, in theory. As the reserves are not used to

control the value of the currency it is not necessary to keep high

levels of reserves (like gold) of foreign countries.

Flexible Disadvantages Floating exchange rates tend to

create uncertainty on the international markets. As businesses try

to plan for the future it is not easy for the businesses to handle

a floating exchange rate which might vary. Therefore investment is

more difficult to assess and there is no doubt that excursive

exchange rates will reduce the level of international investment as

it is difficult to assess the exact level of return and risk.

Floating exchange rates are affected by more factors than only

demand and supply, such as government intervention. Therefore they

might not necessarily adjust themselves in order to eliminate

current account deficits. The floating exchange rate might worsen

existing levels of inflation. If a country has higher inflation

rate than others this will make the export of the country less

competitive and its imports more expensive. Then the exchange rate

will fall which could lead to even higher import prices of goods

and because of cost-push inflation which might drive the overall

inflation rate even more. While flexible exchange rates can ensure

that the country achieves external balance, they do not ensure

internal balance. In several situations the exchange rate change

that reestablishes external balance can make an internal imbalance

worse. If a country has rising inflation and a tendency toward

external deficit, the depreciation of the currency can intensify

the inflation pressures in the country. If a country has excessive

unemployment and a tendency toward surplus, the appreciation of the

currency can make the unemployment problem worse. To achieve

internal balance, the country's government may need to implement

domestic policy changes.


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