Fixed versus floating exchange rates
The exchange rate regime
The exchange rate regime is the way a country manages its currency in respect to foreign currencies and the foreign exchange market. Each country has its exchange rate policy which determines the form of a government influence on the currency exchange rate.
There are three main type of the exchange rate regime:
• a floating exchange rate, where the market dictates the movements of the exchange rate, • and the fixed exchange rate, which ties the currency to another currency, • a pegged float, where the central bank keeps the rate from deviating too far from a target band or value, divides into 2 subtypes: o Crawling bands: the rate is allowed to fluctuate in a band around a central value, which is adjusted periodically, o Crawling pegs: the rate itself is fixed, and adjusted periodically. I’m going to concentrate on the first two of exchange rate regimes.
The fixed exchange rate
A fixed exchange rate is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold. A pegged currency with very small bands is sometimes called as fixed one too. A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to and it can also be used as a means to control inflation.
Advantages of fixed exchange rates
Predictability or even certainty.
The international trade and investments are easier and more predictable. If a company decides to export its goods outside the country or to import them it calculates the prices basing on current exchange rate. The fixed exchange rate ensures that present profitability calculation will be still valid in the future.
A currency speculation is sensible only if a speculator believes that the exchange rate of certain currency will change in the future. If there is no such possibility, what ensures the fixed interest rate, there is no use in speculating.
The fixed exchange rates prevent a government from irrational macroeconomic policy. If a government stimulates excess demand and in order to gain popularity just before elections it affects balance of payments and will be forced to use capital reserves to restore equilibrium.
Disadvantages of fixed exchange rate.
Influence on business and economy.
An international economic downturn or foreign competition increase can cause the country export decrease and thus create a balance of payments deficit. Without currency rate change the government or the central bank of can be forced to increase interest rates. The higher interest rate rises the cost of borrowings and thus cost of products. The exported goods will be even more uncompetitive what reduces the export. The higher interest rates also force to save money and dampens internal demand and investments. All these leads to recession which reduces demand for imports. From the other side the higher rates attract foreign capital. Lower import and foreign capital inflow improve the balance of payments. The fixed exchange rates cause the domestic policy to be constrained by the balance of payments.
World depression probability
If the balance of payments is be the most important all countries would tempt to achieve surplus and build up reserves but not all of them can be successful in that. The world payments flows have to be balanced so if some countries gain surplus others suffer deficit and fighting against it causes recession. It can lead to general world recession or limitation in growth the world economy.
International liquidity problem
An increase of international trade needs adequate international liquidity assured by appropriate supply of acceptable currencies. Countries would have to gain enough currency reserves to be able to use them during...