A Report on Reasons why Governments Prefer Financial Systems featuring Fixed - Essay Example

?A Report on Reasons why Governments Prefer Financial Systems featuring Fixed Exchange Rates while Private Investors Favor Floating Exchange Rates. Fixed/ Pegged Exchange Rates Fixed exchange rate, also called a pegged exchange rate, is sett by the government and is maintained as the official exchange rate. In order to determine the set price, the European Union determined their currency against that of major world currencies like the US dollar. A fixed exchange rate is a rate whose currency amount is determined in advance. On the other hand, a floating rate of exchange is the one that is moving and received currency depends on exchange time. To maintain their local exchange rate, central banks of European Union members bought and sold their own currency in foreign exchange markets, and in return, they acquired their pegged currency. For example, if the value of a single local unit currency is US$4, the central bank ensures that those dollars can be supplied in market by the country. High foreign reserve levels are required so as to maintain the rates (Eichengreen & Ricardo, 1999). High foreign reserve levels also ensure that there is good money supply thus preventing inflation/ deflation. An exchange rate refers to the rate at which one currency is exchanged for another. Therefore, it is the value of a country’s currency in terms of another. From 1870 to 1914, the global exchange rate was fixed. During that time, currency was likened to gold, implying that a local currency’s value was set at a fixed exchange rate that was determined in terms of gold ounces, that is, the gold standard (Eichengreen & Ricardo, 1999). This allowed free capital mobility and global stability in trade and currencies. The gold standard was abandoned when World War II started, but the end of the Second World War, the Breton Woods conference sought for efforts to stabilize the global economy and increasing global trade by establishing basic regulations and rules that governed international exchange. This led to the establishment of International Monetary Fund (IMF) for foreign trade promotion and monetary stability maintenance of countries and hence of the global economy. It was agreed that the exchange rate would be fixed, in terms of the US dollars, which was then pegged to gold (US$35 per ounce) (Obstfeld & Kenneth, 1995). This means that a currency’s value was directly converted in terms of its value to the US dollar. For example, to buy a euro, the Euros had to be converted into US dollars, and then into gold value. This peg was maintained till 1971, US dollar could not hold the pegged rate value of US$ 35per gold ounce. Since then, many governments adopted the floating rate system and attempts of returning to gold like a peg together with a global peg were completely abandoned. Why Governments Prefer Fixed/ Pegged Exchange Rates Governments prefer fixed exchange rates because they ensure economic stability, especially in current developing nations, where a country can decide to fix its currency in order to stabilize the atmosphere thus ensuring foreign investment. This is because a peg gives the investors their investment value, thus relieving them from fluctuation worries unlike under a float (Calvo, 2002). A pegged currency also helps in lowering inflation rates and generating demand, which further increases a currency’s stability confidence. However, fixed regimes can cause serious financial crises because it is hard to maintain a peg in the long run. This was experienced in 1995 in Mexico, 1997 in Asia and Russia. Therefore, the governments could not meet the demands of a high value for their currencies to the peg resulting into overvaluing of their currencies. With panic and speculations, investors quickly removed their money out of these countries, and convert it to foreign currencies before the local currency was devalued against the peg. Eventually, foreign currencies became depleted. In Mexico, the government devalued the peso by 29.98%. Eventually, in Thailand, the government eventually allowed floating of currency, where it lost its value by 50% by 1997 as demand and supply in the market readjusted the local currency value (Calvo, 2002). Countries with pegged currencies are normally associated with weak regulating institutions and unsophisticated capital markets. Therefore, the peg ensures a stable environment. To maintain a peg, a market has to be mature and strong. When a country devalues its currency, it is also supposed to make economic reforms such as greater transparency implementation in order to ensure that its financial institutions are strong (Calvo, 2002). However, some governments may opt for a crawling peg, where it is allowed to periodically assess its peg value and accordingly change the peg rate. This, usually, causes devaluation, which can be controlled to prevent market panic. This is the method used to shift from a pegged to a floated regime. The other reason why governments prefer fixed exchange rates, as Calvo, (2002) observes is because of its predictability. Therefore, individuals and businessmen can certainly plan their activities. Why Private Investors Favor Floating Exchange Rates Floating exchange rate is determined by market forces of demand and supply. This demand and supply keep fluctuating from time to time and therefore, private investors prefer it to fixed exchange rate because they can be able to speculate how the market will behave and hence know when to buy, when to sell and when to hold and wait. However, when the exchange rate is fixed, they are likely to incur losses if the demand falls (Bhagwati, 1998). Therefore, they can effectively maximize their profits during high demand periods, and try to minimize profits when demand is low. It is also possible to derive the output impact under a float. External shock effects on output can be detected and corrective measures taken in advance when exchange rate is operating under float (Aghion, & Romain, 2006). Elasticity of substitution can also be applied under floating exchange rate. Under a floating exchange rate, balance sheet effect, depreciation increases investment ratio over net worth by increasing investment price because of increase in debt burden. On the other hand, the ability of floating exchange rate to stabilize output increases the share of similar import goods increases and foreign currency debt levels decreases (Aghion, & Romain, 2006). The effect of output under a fixed exchange rate is higher than under a float. Therefore, investors prefer floating exchange rates because to better absorb real shocks and adjust accordingly. The IMF‘s classification of exchange rate regime shows that the response of output under a float is much smaller (Aghion, & Romain, 2006). For example, a 0.2% shock in output fall under a peg leaves the output under a floating exchange rate constant and unchanged. Foreign currency indebtedness shows that a floating exchange rate insulates shocks of trade much better when the debt is low. Response of trade shock under a fixed exchange rate regime has no any specific sensitivity to foreign currency debt extent; however, a floating exchange rate shows an increase in response with an increase in debt. Conclusion A fixed exchange rate is a rate whose currency amount is determined in advance. On the other hand, a floating rate of exchange is the one that is moving and received currency depends on exchange time as it depends on market forces of demand and supply. Governments prefer fixed exchange rates because they ensure economic stability. They also reduce inflation and effects of inflation especially in developing countries. a peg gives the investors their investment value, thus relieving them from fluctuation worries. However, fixed regimes can cause serious financial crises because it is hard to maintain a peg in the long run. On the hand, private investors prefer it to fixed exchange rate because they can be able to speculate how the market will behave and hence know when to buy, when to sell and when to hold and wait. Recommendation Governments should apply a floating exchange rate because its long-term effects are favorable unlike for fixed exchange rates. Additionally, they encourage private investors to invest thus increasing development and GDP. A Report on how Membership of the Eurozone Limited the Scope of the Governments of Greece and Ireland to Respond to Financial Issues and how the Responses of the two Governments might have been Different had they Retained their own National Currencies Eurozone is an area of monetary and economic union consisting of 17 member states which use euro as a sole legal tender and economic currency. A contributing factor in the recent financial issues affecting Greece and Ireland has been that each of these Countries is a member of the euro zone. One of the contributing factors is the fiscal policies of the eurozone. For example euro zone members have to abide by the growth and stability pact that sets limits on national debt and deficits, with sanctions for deviations. Originally, the pact had set a GDP of 3% limit for national debts and annual deficits for all member states. Any states that exceeded this amount were fined. In 2009, Greece and Ireland exceeded amount and this negatively affected their economy. Unfortunately, Europe has no room to ease these monetary and fiscal policies, and this really lowered their GDP growth rate to 0.5%. Unfortunately, there was no improvement during the second quarter as it only showed a 0.4% gain. Global financial crisis between 2007 and 2008 left eurozone in official recession for the first time in 2008’s third quarter (Willis, 2010). A bank rescue plan, where governments would guarantee interbank lending and boost their finances by buying into banks, was agreed. However, crisis coordination is vital to prevent one country’s actions from harming others and increasing credit shortage problems and bank solvency. The great depression that were unilaterally taken by eurozone deepened Greece’ and Ireland’s economic loss. Early 2010 sovereign debt crisis brought fears on eurozone countries like Ireland and Greece, together with Spain, Portugal and Italy, (Irvin, 2010). With Greece experiencing serious economic difficulties, EU developed a plan to help in its recovery and accepted to allow the country to bail out if it wanted (Oakley & Ralph, 2009); the crisis has brought new discussions about fiscal integration as federal budget and treasury lack being the major weaknesses in the eurozone (Irvin, 2010). Speculators attacks on Greece left many, as well as the government of Greece, it as a eurozone attack where Greece was being used like the weak-link Irvin (2010) observes. In April 2010, a bailout of 30 billion Euros was triggered for Greece (Willis, 2010). Economic crisis made eurozone to be more integrated to fiscal union from bailing out of member states. Though the European Union was seen to be controlled by sovereign nations but in mid 2010, a broad agreement was reached for all member states to review each others budget before it is presented to the national budget. Each country had to indicate its estimated growth, inflation expenditure and revenue. If a country expected a deficit, the country had to justify it to all EU members, but a debt than exceeded 60% of GDP was to face greater scrutiny. This policy made small players like Greece and Ireland to face so much scrutiny and discrimination because of their huge debts thus negatively affecting their budget. Poorer states like Ireland and Greece also were negatively impacted by the growth and stability pact which stated that such countries had to face sanctions before they could reach the limit of 3%. Countries like Ireland and Greece are also not allowed to vote because of breaching the rules. Growth and stability pact was newly reformed in March 2011 in order to strengthen the rules through adoption of automatic procedures for imposing penalties if a country breaches either the debt or deficit rules, thus further complicating the economic situations in those countries, something they could easily avoid or sought for external solutions if they were not members of the eurozone members. On March 2010, the council of European nations finally agreed on a mechanism for bailing out Greece, together with any other country that needed it. With the bailout mechanism agreement, eurozone rules were significantly tightened, together with the possibility of doing away with members who repeatedly flaunt restrictions (Willis, (2010). Bailout mechanism was initiated in April 2010 with Greece being loaned 30 billion Euros (Oakley & Ralph, 2009). In May, a full fund, 750 billion Euros, was established by EU to wholly stabilize the eurozone. This further deepened the debts of Greece, thus further pushing it into facing sanctions and fines, together with voting rights. If it was not a eurozone member, it could have acquired similar loan from other foreign nations without facing such negative consequences. The proposal of European Monetary Fund (EMF) was backed by majority of eurozone members, (Wray, 11 April, 2010), who were quit aware of what was missing in their common tool box, which would tackle serious and foreseen crises in countries of eurozone. However, an EDA or EMF would not in any way help Greece or Ireland at that time. This proposal has resulted into the biggest overhaul that the eurozone has ever experienced since its launch. With the guarantee of bailing the system that is market based is seen as a means of collapsing Greece, together with other small nations like Ireland. The other weak point in the design of eurozone it requires to give up sovereignty chunk financial or funds independence, which give eurozone a stronger base required by a fiscal-political union. Conclusion Membership of the euro zone has limited the scope of the governments of Greece and Ireland to respond to financial issues due to tight fiscal and monetary policies that that they have to adopt besides strict terms of membership that have left them like captives in the EU. the responses of the two governments might have been different had they retained their own national currencies because it could be easier for them to apply appropriate measure to positively address their financial issues which are not allowed in the union like borrowing from other foreign countries or adjusting their budgets. Recommendation It is recommended those superior countries in an economic to consider small and less superior countries who are their members. They should not formulate very strict measures that leave such countries in a situation that cannot allow them to effectively solve their financial problems. References Aghion, P. & Romain, R. (2006). “Exchange Rate Volatility and Productivity Growth: The Role of Financial Development.” Working Paper 12117. National Bureau of Economic Research; Cambridge, MA. Bhagwati, J. (1998). “The Capital Myth: The Difference between Trade in Fixed Exchange Rate and Floating Exchange Rates.” Foreign Affairs 77 (May/June): 7–12. Calvo, G. A. (2002). “Fear of Floating.” Quarterly Journal of Economics 117: 379?408. Eichengreen, B. & Ricardo, H. (1999). “Exchange Rates and Financial Fragility.” In New Challenges for Monetary Policy. Kansas City, MO: Federal Reserve Bank of Kansas City. Irvin, G. (2010). Comment: How Serious is the Euro Debt Crisis?, EU observer http://euobserver.com/19/29501. Obstfeld, M. & Kenneth R. (1995). “The Mirage of Fixed Exchange Rates.” Journal of Economic Perspectives 9: 73–96. Oakley, D. & Ralph, A. (2009) Eurozone shows its Strength in a Crisis, Financial Times. Willis, A. (2010). Eurozone will Bail Out Greece if Needed, EU Observer. Willis, A. (2010). EU Data Confirms Eeurozone's First Recession, EU Business.com. Observed on 10th June, 2011 from http://www.eubusiness.com/news-eu/1231409822.27/, retrieved 26 February 2011. Wray, R. (11 April, 2010). EU Ministers Agree Greek Bailout Terms. The Guardian. Read More