Fixed and Floating Exchange Rates - Coursework Example

An economy which has strong roots and resources contributes to the growth and well being of people. The growth rate of an economy is depicted by the GDP and per capita income. Many factors contribute towards making an economy successful. Some of these factors are agriculture, infrastructure, exports, and production as all this contribute towards the growth. Exports form an integral part of GDP and economies want to have a higher share in the world market. Dealing with other economies through export and import raises the mechanism of foreign exchange. Economies have to pay the other economy in their local currency which makes exchange rate important. The paper thus looks into the two types of exchange rate prevalent and the benefits drawn from each. It also looks into the manner international business is conducted and the effect exchange rate has on world economies. Foreign exchange is “a mechanism through which two country adjust their balance of payments through different instruments”. (Scott, 2006, pg 3) An economy transacts with the other and needs to pay for the goods or services consumed. Foreign exchange is a mechanism through which economies pay the other country. Foreign exchange is thereby measured through fixed and floating exchange rate which determines the value of the currency. Both these mechanisms are important and help the economy in different manner. There has been a shift towards floating exchange rate and few economies like China still practices fixed exchange rate. A descriptive analysis of both the fixed and floating exchange rate is provided. Fixed Exchange rate is the “exchange rate between currencies which has been fixed by the government and is not allowed to change by the supply and demand function for the currency”. (Fixed Exchange Rate, 2010, pg 1) This type of exchange rate is slowing vanishing and few economies like China uses the fixed exchange rate. In this rat the government fixes the value of the currency against certain currency or against gold. The government ensures that the sufficient amount of currency or gold is kept with the Central Bank and measures are taken so that the value of the deposits doesn’t fall as it can affect the exchange rate. (Grilli, 2004, pg 147) Fixed exchange rate requires the government to be active and take all necessary steps to ensure that the exchange rate doesn’t fall below a certain level. If this happens then the government has to use its reserves to ensure that it purchases the currency which will drive the demand for currency and help to achieve the desired level of exchanges. (Fixed Exchange Rate, 2010, pg 1) Thus government intervention becomes very important and all measures should be directed towards it. A study in this direction shows that “government is forced in a vicious circle when it tries to ensure the value of the currency by raising the nominal interest rate”. (Bensaid & Jeanne, 1997, pg 1467) This increases peculation and creates a situation where controlling the value of the currency results in increased speculation and managing the fixed exchange rate becomes difficult. Fixed Exchange rate helps the economy in a number of ways due to the inherent benefits it brings along with it. Some of the advantages are Firstly, it helps to check inflation. If a country has a fixed rate then the government has to ensure policies that keep inflation low otherwise the value of the currency will fall below the level the government intends to keep which will make the exchange rate ineffective. (Benefits, 2008, pg 1) This thereby helps to keep inflation low though it is not the motive for having a fixed exchange rate. Secondly, it reduces uncertainty as the exporters and importers know the rate which is prevalent. Decision based on those ensures that the fluctuations that might happen in case of floating exchange rate are dealt with. (Benefits, 2008, pg 1) This help to reduce risk and ensure that sudden shocks in the exchange rate don’t affect business transactions. There are various cost associated with fixed exchange rate and special attention and measures need to be taken to ensure those. They are as Firstly, fixed exchange rate requires economy to be stable which is not possible due to the changing world environment. (Benefits, 2008, pg 1) With increasing completion and integration of world economies it is difficult for the economy to be stable in the long run which reduces the benefit of having a fixed rate. Secondly, fixed exchange rate requires confidence in the capital market. (Fixed Exchange Rate, 2010, pg 1) This is a difficult phenomenon because capital markets goes through ups and down and maintaining the same level of confidence is difficult. This was seen in Argentina (Fixed Exchange Rate, 2010, pg 1) where the fixed exchange rate was not able to keep with the confidence in the capital market thereby making the whole system inefficient. Thirdly, it increases the chances of black marketing (Fixed Exchange Rate, 2010, pg 1) as people will hoard the currency to increase the value of the currency by creating a shortage which goes against the principle of the fixed exchange rate which will make it difficult for the government to control. The fact that fewer economies are looking towards fixed exchange rate is highlighted through many instances. Recently, the Bank of Thailand also said that it would not use the fixed exchange rate as it did in 1997 which caused the crisis and will look towards a floating exchange rate. (BOT, 2010, pg 1) Floating exchange rate is the “rate which is determined by the demand and supply of currency in the world markets”. (Lai, Hsiao & Chang, 1993, pg 52) Here the market corrects by itself as the determining forces are the supply and demand. For example if the value of dollar falls due to decrease in demand it will have an effect on imports as it will become expensive thereby making the economy rely on self sufficiency. The exchange rate in floating regime is determined by the supply and demand. In the fixed rate government plays a role to ensure supply and demand whereas in the free market the forces determine the rate. The exchange rate is determined as below The above chart shows that as the demand for a currency rises the value of the currency appreciates keeping the supply same. (tutor2u, 2010, pg 1) It shows that demand plays a role in deciding the value of the currency. The chart below will show the effect of supply on the exchange rate. The above chart shows the manner supply and demand affects the exchange rate which leads either towards an appreciation or depreciation of the currency. (tutor2u, 2010, pg 1) This has grown the importance being laid to floating exchange rate and economies are looking towards floating exchange rate. Floating exchange rate has certain benefits which helps economies to look towards a floating exchange rate. The benefits are Firstly, it helps to provide flexibility in determining the interest rate. (tutor2u, 2010, pg 1) As the market forces determine the exchange rate so the government can leave the interest rate to be determined by the market which increases its efficiency and ensures that government intervention is reduced. Secondly, it helps to reduce intervention from the government. (tutor2u, 2010 pg 1) Since, the market forces determine the rate so intervention from the government reduces which helps economy to determine the effective rate. Thirdly, floating exchange rate allows the government to choose any policies as the market forces will adjust accordingly and determine the exchange rate. (Wong, 2007, pg 1) This gives freedom to the government to determine any policies that they want to follow thereby increasing the efficiency and role of government in determining the policies. Floating exchange rate also has some cost associated with it. The costs are as Firstly, it increases uncertainty as the exporters and importers don’t know the rate which is prevalent. Decisions based on those are risky as there is no guarantee on the exchange rate which might lead towards a loss to either the exporter of importer. Secondly, it increases speculation as people trade in it. (Wong, 2007, pg 1) This raises uncertainty about the exchange rate as it gives rise to speculation. This can have an effect on the exchange rate and have a huge role in determining the rate. The usage of both the fixed and floating exchange rate in the international arena highlights the importance different economies lay importance to. In this competitive world it is seen that more economies follow a floating exchange rate as compared to the fixed exchange rate. This is due to the advantage floating exchange rate brings with it. The usage of exchange rate in international business scenario is shown below. International trade has given China a lot of advantage. “It has helped them to move to different markets and grow in size”. The Chinese economy due to “anti-protectionism and the $250 billion support to trade finance” (Xinzhen, 2009, pg 1) will be able to cater a wider market. “They will be able to enter new markets” and check the fluctuations back home. This is helping them to improve their “foreign trade dependence ratio” (Xinzhen, 2009, pg 1) by declining the negative impact. This will give them an advantage and pose better growth rates. The fact that China has a fixed exchange rate has helped the economy as it doesn’t have to face the fluctuations in the value of the currency which is helping it develop policies keeping it in mind. A study in this direction shows that “economies use the J-curve to explain the trade of balance the usage of which has grown after worsening of the value of the domestic currency”. (Mixon & Cott, 1995, pg 25) This is seen in the case of Germany where the economy has been using J-curve to ensure that they are able to ensure their balance of trade. This shows the importance being laid to exchange rate in the international arena where economies are able to fetch a good return by exporting. In the international arena it is seen US having a trade deficit with China due to imports from that country. China has a fixed exchange rate but recent findings have suggested that the Chinese economy which has a fixed exchange regime is flexible compared to the pure fixed exchange rate. (Soofi, 2009, pg 43) This has also been substantiated in a study which further dwells on the point that this will have additional stimuli which will help to improve exports with US and other countries as the exchange rate has become more flexible. Economies having a floating or fixed exchange rate look towards export promotion and import substitution strategy to ensure growth. Economies use import substitution to protect “the infant industries especially heavy industries where they produce goods by themselves by changing some government policies to protect those”. (Nishkantha, 2007, pg 6) Thus, protectionism acts as a strategy for import substitution. On the other hand the economy which is sound on certain things will look for export promotion. For example, the Middle East which has oil reserves so it looks forward to exporting those by banking on the core capabilities and importing the necessities. This helps to ensure that the foreign exchange doesn’t get depleted at the same time the exchange rate is strong which increases the bargaining power of the currency. Thus economies all around the world use either fixed or floating exchange rate to ensure their international transactions. This provides ease to the banks as they are able to pay in the foreign currency which has increased the demand for foreign goods. Exchange rate holds an important place for both the importers and exporters and helps to determine the GDP of an economy. Thus, economies are laying importance to the exchange rate regime and it is seen that more economies prefer floating exchange rate as the market forces determine the exchange rate thereby ensuring better competition and growth for all economies. (1992 words) References Bensaid B & Jeanne O, 1997, “The instability of fixed exchange rate systems when raising nominal interest rate is costly”, European Economic Review, Volume 41, Issue 8, page 1461 – 1478 BOT, 2010, “BOT: Fixed exchange rate dangerous”, Bangkok Post, Business News Benefits, 2008, “Benefits & costs of fixed exchange rate”, pg 1 retrieved on October 19, 2009 from http://www.economicshelp.org/blog/economics/benefits-and-costs-of-fixed-exchange-rates/ Fixed Exchange Rate, 2010, “Fixed Exchange Rate, 2010”, Economy Watch, pg 1 retrieved on October 19, 2010 from http://www.economywatch.com/exchange-rate/fixed.html Grilli V, 2004, “Buying and selling attacks on fixed exchange rate system”, Journal of International Economics, Volume 20, Issue 1-2, pg 143-156 Lai C, Hsiao W & Chang W, 1993, “Managing floating exchange rate, intervention policy and macroeconomic policies”, Journal of Economic Studies, Volume 12, Issue 4, page 52 – 57 Mixon & Cott, 1995, “Exchange rate and trade balances: evidence from Germany”, Atlantic Economic Journal Articles, Volume 26, Issue 3, page 23-32 Nishantha K, 2007, “Export Promotion or Import Substitution”, the Sunday Times Online, Financial Times, pg 6 Soofi A, 2009, “China’s exchange rate policy and United States trade deficit”, Journal of Economic Studies, Volume 36, Issue 1, page 36-65 Scott U, 2006, “Foreign Exchange”, Questia Online Journal, pg 3 Tutor2u, 2010, “fixed and floating exchange rate”, retrieved on October 19, 2010 from http://tutor2u.net/economics/content/topics/exchangerates/fixed_floating.htm Wong S, 2007, “Fixed versus floating exchange rate”, pg 1, retrieved on October 19, 2010 from http://www.articlesbase.com/finance-articles/fixed-versus-floating-exchange-rate-229803.html Xinzhen L, 2009, “The China Advantage”, Beijing review.com, retrieved on October 19, 2010, pg 1 from Read More