Intermediate Macroeconomics - Essay Example

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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. …
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Intermediate Macroeconomics
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Download file to see previous pages 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...
This essay approves that 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 report makes a conclusion that 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. ...Download file to see next pagesRead More
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