Intermediate Macroeconomics - Essay Example

?Currency Exchange: Should Exchange Rates be Fixed or Floating? Introduction In today’s competitive business environment, foreign exchange or currency exchange is of great importance. Currency exchange is formally referred to a system of exchange rate between currencies that assists countries with different currencies to involve in international trade. Currency exchange rate is defined as “the amount of one currency it takes to buy one unit of another currency” (Randel, 2011, p.CXV). The currency exchange rate systems can be broadly classified into two such as fixed or pegged exchange rate system and flexible or floating exchange rate system. Under fixed exchange rate regime, governments keep the value of their currencies fixed against one another whereas a currency’s value is allowed to change in accordance with foreign exchange market fluctuations. The debate over currency exchange rate can be dated back to several decades. This paper will examine whether exchange rates should be fixed or floating. Since exchange rate greatly influences economic growth of a country, exchange rate setting is of vital significance in international trade. This paper will specifically discuss merits and demerits of both fixed and floating exchange rate regimes. Advantages of fixed exchange rates The most notable advantage of fixed exchange rate is that this condition avoids currency fluctuations and related currency losses. Hence, fixed exchange rate would assist an organisation to get rid of the troubles associated with unexpected global financial market fluctuations. This situation may also aid firms to reduce their investments in currency risk management and thereby strengthen their working capital sources. By avoiding currency fluctuation risks, it is possible to promote level of business stability and which in turn would encourage investors to make more foreign investments confidently. In short, fixed exchange rate may foster global investments and increase the level of international financial transactions. It is clear that better international business relations would assist a country to promote sustainable economic development. It has been identified that when a government allows exchange rate devaluation, this situation is more likely to create an environment of inflationary pressure. It happens because of increase in import prices and fall in incentives to cut costs. Hence, a fixed exchange rate would benefit a nation to keep its inflation low and thereby promote its economic growth. As Frankel (1995, p. 40) points out, fixed exchange can be considered as an effective monetary policy for assuring price stability. Similarly, maintaining fixed exchange rate may be an effective strategy to prevent speculation in foreign currency transactions and thereby stabilise the economies. It must be noted that the exchange rate does not remain permanently frozen under the fixed exchange rate system. Rather the exchange rate is timely and appropriately resent so as to ensure fundamental equilibrium in the balance of payments. Disadvantages of fixed exchange rates Even though a fixed exchange rate may be beneficial to promote certainty of future exchange rates, this concept has many disadvantages. Primarily, a fixed exchange rate would cause conflict with other macroeconomic objectives. Setting fixed exchange rate may reduce financial transactions’ flexibility and hence an economy may face potential difficulties in responding to temporary shocks. Economists opine that fixed exchange rates may lead to current account imbalances. Proper setting of fixed exchange rate would be a difficult task for regulators because the exchange rate is most likely to impact the economic growth of a country. Varying exchange rates raises potential challenges to multinational corporations engaged in international trade. According to Jain and Ohri (n.d, p. 265), the fixed exchange rate system is to be supported with large international reserves and the author finds it as one of the principal demerits of this system. They continue that a fixed exchange rate system is likely to discourage venture capital and this situation would cause difficulties to innovative entrepreneurs. In addition, this system imposes some restrictions on the capital movement in the global market and therefore this practice is likely to impede economic growth. Flexible exchange rate may cause ‘rigidity in resource allocation’ (ibid). However, it is very difficult to maintain a fixed exchange regime and therefore this method is not applicable to all economies. Finally, this system reduces the level of financial advantages a firm can take from engaging in international trade. Advantages of floating exchange rates Flexible exchange rate would be a better strategy to improve the employment rate of a country. The Canadian labour statics vs. exchange rate fluctuation diagram (Chart II) illustrated in the Appendix supports this statement. It is observed that floating rate would fuel deficit countries’ ability to create employment opportunities through various expansionary policies. Another notable merit of flexible exchange rate is that there is no need for international reserves under this policy framework. According to Jain and Ohri (n.d, p. 265), optimum resource allocation, free international capital movement, and promotion of venture capital are some of the significant benefits of operating under a floating exchange rate regime. “One of the advantages of floating exchange rate is that countries are free to pursue their own macroeconomic policies without worrying about maintaining an exchange-rate commitment” (Boyes & Melvin, 2004, p.875). To illustrate, if US regulators maintain a higher inflation rate than that of Japan, the value of dollar will automatically depreciate against yen. Here, the US can adopt the macroeconomic policy it requires regardless of other nations’ policies. In addition, the US can adjust its exchange rate if the country’s inflation rate varies noticeably as compared to other nations. In contrast, if the US fixed the value of dollar relative to the yen, both the countries (US and Japan) would not be able to follow independent policies and maintain the exchange rate. Satija (n.d, p. 522) argues that exchange rate fluctuations are capable of providing an automatic adjustment for economies with a huge balance of payment deficits. Freeing internal policy, absence of crises, and increased flexibility are some other advantages of maintaining a flexible exchange rate regime (ibid). Disadvantages of floating exchange rates Currency rate fluctuation is one of the threatening consequences of maintaining a floating exchange rate regime. Evidences suggest that frequent currency fluctuations in the global financial market may cause significant problems to firms engaged in international trade. To illustrate, when a British firm is exporting commodities to its US client, a sudden appreciation in sterling would probably make the British firm’s exports uncompetitive and hence the organisation may go out of the business. Similarly, unexpected and significant exchange rate fluctuations may sometimes force a multinational corporation to pay higher costs for its imports and this situation in turn would increase the firm’s vulnerability to bankruptcy. The most argued disadvantage of floating exchange rate is that it significantly weakens internal price discipline and allows greater level of inflation. This argument is supported by the fact that the generalised float in 1971 contributed to an increase in world inflation. Market experiences indicate that the probability of speculation is high under a floating exchange rate regime since currency exchange rate is always subjected to fluctuations in such an environment. If speculators expect a further increase in the value of foreign currency when its current value is above the trend level and expect a further fall in the value of foreign currency when its current value is below the trend level, they tend to buy foreign currency at above trend and sell at below trend level. This type of destabilising speculators may lose their money by buying at high prices and selling at low prices over each exchange rate movement cycle. Probably, they may eventually go bankruptcy if they continue this practice. Hence, floating exchange rate system leads to the creation of trade deficits. Analysis The above sessions indicate that both flexible and floating exchange rates have several advantages and disadvantages. Hence, none of the two exchange rates regimes can be considered as more potential than the other. This view is supported by the chart I given in the Appendix. It is advisable for countries to give focus on their growth priorities while choosing an exchange rate system. As we discussed earlier, a flexible exchange rate regime increases the likelihood of price inflation whereas it promotes employment opportunities in the country. Therefore, countries which are greatly concerned with creating employment opportunities but do not care much about price inflation may opt a flexible exchange rate system. Evidently, a fixed exchange rate regime would be beneficial for smaller nations like Denmark and Belgium since foreign trade plays a pivotal role in promoting the growth of these economies. Heavily fluctuating exchange rates can have a negative impact on these nations’ economic development. In addition, fixed exchange rate may be a better policy for developing nations too because this strategy would assist those countries to effectively carry out their planned development efforts. In contrast, fluctuating currency values would adversely affect developing nation’s smooth economic growth and limit the inflow of foreign capital. Economists opine that developed countries would be benefited more from a floating exchange rate regime since they are economically potential enough to defend huge margin fluctuations. For instance, the United States, the world’s largest national economy, has been operating on a floating exchange rate system since early 1970s. In the view of Hamada (as cited in Trenqualye, 1990), if countries give primary focus on balance of payments and income levels, then a flexible exchange rate system would be more recommendable for them since this policy allows countries to adopt an independent monetary policy and avoid strategic conflicts. In contrast, if countries are mainly concerned with current account or interest rates, then strategic conflicts may be unavoidable under both exchange rate regimes and free-riding behaviour would possibly result in inefficient policies (ibid). Under such circumstances, countries must consider the extent to which they ‘cooperate and coordinate their policies’ before making a decision regarding exchange rate setting (ibid). In addition, any of these policies would not be permanently beneficial for an economy and hence policymakers should timely evaluate their exchange rate regimes. Admittedly, regulators have to take a range of factors into consideration before choosing either a fixed or a floating exchange rate regime. Conclusions From the above discussion, it is clear that either fixed exchange rate system or floating exchange rate system does not have any competitive edge over the other. Each system has its own advantages and disadvantages. Hence, regulators must consider their growth priorities while choosing an exchange rate policy. For small nations and developing economies, fixed exchange rate system is more advisable as this policy would enhance their smooth economic development. On the contrary, a flexible exchange rate system may aid developed countries to promote their growth in international market. References Boyes, W & Melvin, M ., 2004. Textbook Of Economics. New Delhi: Dreamtech Press. Forex nrg. (2012). Canadian Employment Slightly Rose by 18k in December – January Report 2012. Retrieved from http://www.forexnrg.com/canada-employment-rose-and-canadian-forex-exchange-rate-january-2012/ Frankel, JA., 1995. Monetary regime choice for a semi-open country. In: S. Edwards (Ed). Capital Controls, Exchange Rates, and Monetary Policy in the World Economy. USA: Cambridge University Press. International Monetary Fund, 2001. Exchange Rate Regimes: Is the Bipolar View Correct? Retrieved from http://www.imf.org/external/pubs/ft/fandd/2001/06/fischer.htm Jain, TR & Ohri, VK., n.d. Introductory Microeconomics and Macroeconomics. New Delhi: FK Publications. Randel, J., 2011. Street Smarts: Beyond the Diploma. USA: Rand Media Co. Satija, K., n.d. Textbook on Economics for Law Students. New Delhi: Universal Law Publishing. Trenqualye, PD., 1990. Monetary policy coordination under fixed and floating exchange rate, The Economic Journal, 100(400), pp. 206-214. Appendix Chart I (Source: International Monetary Fund, 2001). Chart II (Source: Canadian Employment Slightly Rose by 18k in December – January Report 2012). Read More