Analyze Alternative Exchange Rate Regimes - Essay Example

Question List and explain the advantages of the flexible exchange rate regime. Answer. Flexible exchange rate regime permits a country’s currencyto change freely in value against other currency (Piana, 2011). A flexible exchange rate is the relative value of one currency to another controlled by the demand of the market. In this case exchange rate is price, and money is a commodity. All else remains unchanged; the higher demand would lead to appreciation of the currency, while the reduced demand would lead to deprecation of the currency.

All else remains equal higher supply of currency would lead to depreciation of the currency, while the lower supply of the currency would lead to appreciation of the currency. Flexible exchange rate constantly moves back and forth. Most of the country of the world keeps US dollars as a reserve currency against their own money. When we mean flexible exchange rate of a country’s currency, we denote its value with reference to US dollar. Change of international value of the dollar will affect the exchange rate of country’s currency against the dollar.

There is no perfect model (Wray, 2011) to predict the movement of international value of US dollar. There is no perfect model that can predict exchange rate of a country’s currency against US Dollar. Flexible exchange rate has advantages; independent monitory policy, promotes economic development, promotes international trade, and increases international liquidity. Government operating with flexible exchange rate does not undertake responsibility of currency conversion. Government does not need to fear that it will run out of foreign currency reserves.

In case of using flexible exchange rate monitory policy of the country is not limited or affected by the economic conditions of other country. Thus, it promotes economic development leading to full employment. Since, government does not control the exchange rate, restriction on international trade is removed which contributes to free moving of capital among countries. Flexible exchange rate removes the necessity of keeping foreign exchange reserves thus, increases international liquidity of the currency.

Question 2: Criticize the flexible exchange rate regime from the viewpoint of the proponents of the fixed exchange rate regime.Answer.In a fixed exchange rate system, the currency has a target rate based on other currency or basket of other currencies (Wray, 2011). This is how government is controlling value between two currencies. If the government let the currency float it can trigger domestic inflation. Government will be printing paper money, and its monitory policy will be affected, as well as the job market.

When export and import elasticity is extremely low (Wray, 2011), exchange market becomes unstable, which makes weaker currency porn to depreciation. Hence, it is not appropriate to stipulate that flexible rate promotes international trade. It not only affects international trade, but also foreign investment. Flexible exchange rate has an adverse effect on the economy of the country, because it causes a change in the price of exporting and importing goods destabilizing the country’s economy.

Thus, flexible rate does not promote economic development of the country. Flexible exchange rate causes unnecessary capital movement among countries. This encourages speculative activities, thus, seriously harms countryies’ economy.Question 3: Refute the above criticism from the viewpoint of the proponents of the flexible exchange rate regime.Answer.The concept of fixed rate incorporates government’s commitment to convert its currency. Government does not have this commitment with flexible exchange rate.

Flexible exchange rate follows the law of economics; demand and supply of a commodity in the market (“Law of Supply and Demand”). A government cannot outlaw market equilibrium of currency by fixing an exchange rate. Market equilibrium is the spot flexible exchange rate. A fixed rate related to market equilibrium can create appreciation and depreciation. Central bank of the country has to absorb appreciation and depreciation. Thus, a weaker currency with a fixed rate might be more porn to domestic inflation.

The problem might be worse if the central bank does not hold enough foreign exchange reserve in case equilibrium rate fluctuation. Government with flexible rate does not have a problem in keeping foreign exchange reserve. Fixed rate in a real sense is not fixed forever. Central bank can change the rate under its own discretion. This approach discourages long-term foreign investment. Modern financial market has developed sophisticated derivative that allows hedging the future exchange rate fluctuation risk.

Thus with flexible exchange rate long-term foreign investment becomes lucrative. With a fixed exchange rate, a country could make its currency artificially valuable. This discourages international trading. With flexible exchange rate international trading becomes more flexible.Question 4: Discuss the impact the increased volatility in interest and foreign exchange rates has on global institutions.Answer. Global institutions for this question will be considered as separate countries. The answer will focus on the impact of interest and foreign exchange rates on countries’ economic health.

Among many determinants, both exchange and interest rates have a significant impact on countries’ economy. A country’s economic growth depends on commodity trading. Thus, international trading plays a global role in the world economy. A country’s economic growth is determined from export, import and trade balance (Wray, 2011). Exchange rate in this equation plays a significant role. If a country’s trade surplus starts rising, demand of that country’s currency rises too, and opposite when trade surplus drops.

In the first case, appreciation of the currency takes place and in the second case depreciation takes place. Trading between two countries highly depends on the exchange rate of their currencies. Levels and fluctuations in the exchange rate would affect the trading, and thus trade balance, as a consequence create appreciation and depreciation. It is now clear that volatility in foreign exchange rates may collapse a country’s economy. A high exchange rate would tend to reduce export, increase import, thus, destroys local economy.

Depreciation of the currency resulting from lower exchange rate of a country’s currency plays an opposite role. Interest rate on Treasury bond (Wray, 2011) reacts on inflow of foreign capital. Higher interest rate brings more foreign capital to the country. However, a country’s economy may collapse if it does not make additional money from the additional foreign investment. Higher interest rate increases exchange rate and lower interest rate decreases exchange rate. This in turn will affect in the trade balance of the country.

Above discussion demonstrates volatility both in interest and foreign exchange rates bring turmoil on global institutions.ReferencesLaw of Supply and Demand. (n.d.). buzzle.com. Retrieved from http://www.buzzle.com/articles/law-of-supply-and-demand.htmlPiana, V. (2011). Exchange rate. economicswebinstitute.org. Retrieved from http://www.economicswebinstitute.org/glossary/exchrate.htmWray, R. (2011). Alternative Exchange Rate Regimes. Credit Writedowns. Retrieved from http://www.creditwritedowns.

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