What are the advantages and disadvantages of both a fixed exchange rate regime and a flexible exchange rate regime
What are the advantages and disadvantages of both a fixed exchange rate regime and a flexibleexchange rate regime?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 setprice will be determined against a major world currency (usually the U.S. dollar, but also othermajor currencies such as the euro, the yen, or a basket of currencies). In order to maintain thelocal exchange rate, the central bank buys and sells its own currency on the foreign exchangemarket 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 USD3.00, the central bank will have to ensure that it can supply the market with those dollars. In orderto maintain the rate, the central bank must keep a high level of foreign reserves. This is a reservedamount of foreign currency held by the central bank which it can use to release (or absorb) extrafunds into (or out of) the market. This ensures an appropriate money supply, appropriatefluctuations in the market (inflation/deflation), and ultimately, the exchange rate. The central bankcan also adjust the official exchange rate when necessary.FloatingUnlike the fixed rate, a floating exchange rate is determined by the private market through supplyand demand. A floating rate is often termed "self-correcting", as any differences in supply anddemand will automatically be corrected in the market. Take a look at this simplified model: ifdemand for a currency is low, its value will decrease, thus making imported goods more expensiveand thus stimulating demand for local goods and services. This in turn will generate more jobs, andhence an auto-correction would occur in the market. A floating exchange rate is constantlychanging.In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures canalso influence changes in the exchange rate. Sometimes, when a local currency doesreflect its true value against its pegged currency, a "black market" which is morereflective of actual supply and demand may develop. A central bank will often then beforced to revalue or devalue the official rate so that the rate is in line with the unofficialone, thereby halting the activity of the black market.In a floating regime, the central bank may also intervene when it is necessary to ensurestability and to avoid inflation; however, it is less often that the central bank of a floatingregime will interfere.AnswerFixed vs. FlexibleFixed advantagesA 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 goingto change they can plan ahead in their productions. Inflation may have a harmful effecton the demand for exports and imports. To ensure that inflation is kept as low aspossible the government is forced to take measurements, to keep businesses competitivein foreign markets. In theory a fixed exchange rate should also reduce speculations inforeign exchange markets. In reality this is not always the case as countries want tomake speculative gains.Fixed DisadvantagesThe government is keeping the exchange rate fixed by manipulating the interest rates. Ifthe exchange is in danger of falling the government needs to increase interest rates toincrease demand for the currency. As this would have a deflationary effect on theeconomy the demand might decrease and unemployment might increase. A governmenthas to maintain high levels of foreign reserves to keep the exchange rate fixed as well asto instill confidence on the foreign exchange markets. This makes clear that a country isable to defend its currency by the buying and selling of foreign currencies. Fixing theexchange rate is not easy as there are many variables which are changing over time ifthe exchange rate is set wrong it might be hard for export companies to be competitivein 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 competitivewhich might lead to a disagreement between countries as they might see it as an unfairtrade advantage.Flexible AdvantagesAs the exchange rate does not have to be kept at a certain level anymore interest ratesare free to be employed as domestic management policies(Appleyard 703). The floatingexchange rate is adjusting itself to keep the current account balanced, in theory. As thereserves are not used to control the value of the currency it is not necessary to keep highlevels of reserves (like gold) of foreign countries.Flexible DisadvantagesFloating exchange rates tend to create uncertainty on the international markets. Asbusinesses try to plan for the future it is not easy for the businesses to handle a floatingexchange rate which might vary. Therefore investment is more difficult to assess andthere is no doubt that excursive exchange rates will reduce the level of internationalinvestment as it is difficult to assess the exact level of return and risk. Floating exchangerates are affected by more factors than only demand and supply, such as governmentintervention. Therefore they might not necessarily adjust themselves in order toeliminate current account deficits. The floating exchange rate might worsen existinglevels of inflation. If a country has higher inflation rate than others this will make theexport of the country less competitive and its imports more expensive. Then theexchange rate will fall which could lead to even higher import prices of goods andbecause 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 thatreestablishes external balance can make an internal imbalance worse. If a country hasrising inflation and a tendency toward external deficit, the depreciation of the currencycan intensify the inflation pressures in the country. If a country has excessiveunemployment and a tendency toward surplus, the appreciation of the currency canmake the unemployment problem worse. To achieve internal balance, the countrysgovernment may need to implement domestic policy changes.Q1 a)Explain why a stronger dollar could enlarge the U.S. balance of trade deficit. Explainwhy a weaker dollar could affect the U.S. balance of trade deficit.a. The dollar is presently weak and is expected to strengthen over time. These expectationsaffect the tendency of U.S investors to invest in foreign securities because the value of U.Sdollar decrease will lead to the U.S company get less profit and earn less money.Consequently, U.S companies will pay fewer dividends for investors who invest in thesecompanies. So, investors will tend to invest in foreign securities where they can get higherdividend. On the other hand, a weak currency can reduce unemployment but maybe it canlead to high inflation, and simultaneously it may reduce U.S imports and boost U.S exports orbuy more goods than it sells abroad (imports exceed exports). Another thing, in the long run,trade deficits may be expected to contribute to a weaker dollar, as the economy adjusts tocreate the surpluses needed to repay foreign investors. However, in the short run, therelationship between the trade deficit and the dollar is weak, and the value of the dollar isdetermined largely by investor preferences for U.S. dollar assets.On the other hand, when U.S dollar is strong again, it will make the value of U.S dollarincrease. A strong dollar will make exports more expensive to foreign consumers and alsomake imports cheaper. Hence, it encourages imports and reduces exports, and maybeincreasing the balance of trade deficit. However, when the U.S dollar has stronger than otherdollars such Singapore dollar, Yen, Euro or Canadian dollar, the value of the U.S dollar is adependant variable by which it is determined by supply and demand. The consumptions will
reduce and exports are the same, and against imports will increase. So it will make toenlarge the U.S balance of trade deficit. For instant, in 2006, U.S exports to China wereabout $55 billion, but imports from China were about $255 billion, which result in a balance oftrade deficit of $200 billion with China (Jeff Madura, 2008, p.26).b. A current account deficit in the U.S...