Fixed and Floating Exchange Rates Systems - Coursework Example

Running Header: Fixed and floating exchange rates systems Student’s Name: Instructor’s Name: Course Code: Date of Submission: Fixed and floating exchange rates systems Introduction The rate at which a currency is exchanged on another one is called the exchange rate. The exchange rate is usually different from one economy to the other at it depends on the economic variables. Changes in the economy such as the balance and unbalance in the economy and the changes in the monetary and fiscal policy are causes of the changing exchange rates. The state of a countries budget, the international policy and the development of a countries economy also affect the exchange rate of that particular country. Recent studies about the world exchange rate system have shown that the system have moved from fixed exchange rate systems to floating exchange rate system. The above study explains the two exchange rate systems and what impact they cause to the local and international economy. According to the history of the exchange rate system, the first monetary system used was commodity money. Calvo and Reinhart (2002) describes that this is where the exchange rate system depended on the amount of gold in the coin and therefore values the coin with a higher content of gold. The other system used was paper money but it had the same purchasing power just like the coins did and therefore did not last for a long time. The gold standard was the other system after paper money and it made other countries exchange rates be equal to the amount of gold linked to the currencies. The system represented a fixed exchange rate system since the content of gold in every currency was fixed. With this system, the demand of a particular currency depended on the currency credibility and therefore countries with weak economic development had less credibility as compared to the developed countries. However, after World War 1, most countries decided to improve their economic conditions and increased their purchasing power of their countries therefore increasing currency credibility (Matthew 1992, pp. 267-289). This caused a weakness of the fixed exchange rate system since countries with weak currencies were the ones affected thus worsening the position of their economies. Krugman (2005) shows that after World War 2 the Bretton woods system which existed until 1973. This offered a fixed system which comparing other currencies not by gold but according to the US dollar. The US dollar on the other hand was fixed by the exchange rate of gold and this situation strengthened the US dollar and on the other hand affected the economies of other countries. In an attempt to solve the inequality among different economies, the International Monetary Fund (IMF) emerged. This organisation was to offer assistance or giving loans to the weak economies though the gap still remained and therefore there was need for changing the system. There was a major controversy between exchange rates and the government policies. This is because the fixed exchange rates stabilized various economies and offered better conditions since it was easy to predict the rates and therefore could plan their businesses. However, there was need to abolish instability and need to facilitate economic growth in various countries. This was to be achieved by removing al, the restrictions and to include the government in setting up monetary and fiscal policies that could eliminate economic crises such as unemployment and inflation. Marston (2000, pp. 27-36) shows that in 1971 the US dollar was attacked which improved its value against other currencies and the US government failed to protect the value of the dollar therefore causing the floating system. Various attempts were made of fixing the value of the dollar though there was no significant change as the US dollar remained strong among other currencies and since then the world exchange rate changed from being a fixed system to a floating system. Fixed exchange rate The government sets this system and it is set according against the major currency which is the US dollar. Lawrence (2000) describes that in this system the Central Bank controls the stability of an economy by buying or selling the countries currency on the foreign exchange markets to get the foreign currency. To maintain the fixed rate system, the central bank must ensure that it has enough reserve to supply to the market. The presence of foreign reserves ensures effective supply of money in the economy thus controlling inflation and deflation rates. Advantages of fixed exchange rate system Firstly, the system offers stability to many enterprisers by facilitating international trade. The rate is always stable and therefore importers and the exporters do not have to worry about the depreciation and the appreciation of the currency value. Marris (1995) argues that it also enables producers to maintain the quality of their output thus enabling the products to be competitive in the international market. To the government, the fixed exchange rate system helps in reducing the level of inflation in the country as well as facilitating international trade. Secondly, the fixed exchange rate is important as it reduces the speculative mentality. Disadvantages of fixed exchange rate system Firstly is that the system is highly vulnerable to attacks from speculative intervention. Due to excess in supply or demand in any economy, a gap is created between resources and demand therefore reducing the value of the currency. Secondly, the system does not yield much benefit to the economy for example there is no economic growth since the exchange rate system does not change the economic condition of a country. Floating exchange rate This is determined by the supply and demand in the market and it is said to be self correcting since the effects caused by the system will be corrected in the market. Foe example once the demand for a currency is low, the value decreases therefore leading to the increased prices of the imported goods in the market. This therefore enables more people to purchase local goods and services which are cheaper and the results of this is creation of more job opportunities in that economy. In reality, there is no currency that remains completely fixed because even in a fixed system, the market pressures can influence changes in the system (Hansen and Robert 1999, pp. 29-53). Advantages of floating rate system Firstly, the system enables quick adjustment of the economy due to its flexibility. The countries economy is also in a position of improving due to the changing market conditions. The system also allows the economy to maintain currency outflow and inflow therefore maintaining the balance of payments. The situation improves competitiveness of the domestic goods in case the currency in the market appreciates and vice versa. Secondly, the floating exchange rate system is preferred since it is capable to determine interest rates more easily. This therefore enables to control the economy from financial crisis such as inflation. Thirdly, the exchange rate system enables the government to implement effective monetary and fiscal policies. These are made differently in order to beat the possibility o instability therefore adjusts to the economic conditions (Dixit 1999, pp. 20-28). Disadvantages of floating exchange rate system Firstly, the system is said to cause instability in the market. It also does not facilitate international trade since importers and exporters fear currency depreciation and appreciation. The system is therefore able to lead to an economic crisis due to instability of the countries currency. However, various studies have shown that the system does not cause instability of the economy but it is caused by the government policies implemented by a particular country. According to Milton Friedman (1993), the effect of flexible exchange rate appears to be fewer that those of the fixed exchange rate system. In Germany for example, the purchasing power of DM was above 20 percent the power of USD but in 1980s it changed to 25 percent below the USD. The DM then returned to 25 percent above the purchasing power of USD and the effect of this was said to be the instability of the countries economy. The prices of goods were stable among other importing countries. Economic stability This refers to an economy that is characterized by a constant growth and at the same time maintaining low inflation rates. This is lacking excessive fluctuations occurring in the macro economy. An economy with a stable economy benefits from increased productivity, efficiencies and low unemployment. The increased growth of international trade has led to other countries economic stability affects others economy. Dornbusch (2000, pp. 61-76) shows that foreigners lose significant amount of money once they invest in countries whose economic status is unstable. To examine the stability of an economy, business cycles are applied which consists of depression, recession stage, the recovery stage and peak period. A country that has a major gap between its depression stage and its peak stage is said to be economically unstable. An unstable economy is also caused if a country stays in the depression stage or recession stage for a long time since this may turn out to be a financial crisis. The major causes of economic instability include changes in house prices, fluctuations in the stock markets, the global credit markets and the changes in interest rates. These factors are capable of reducing international business for example a major fall in the stock market may lead to reduced consumer confidence therefore resulting to a recession. Global factors also lead to economic instability for example if China’s economic boom would reduce then this would cause major changes in the global market. According to Dale (2002) to reduce the impact of the unstable economy, policymakers introduce incentives that facilitate the path to recover from the instability. Some of the methods used in stabilizing an economy include creating more job opportunities, controlling the effects of inflation and stabilising the exchange rate of that particular country. Money is therefore injected back into the economy through increased financing and inflation rate is also controlled since high inflations discourage global trade. Levy-Yeyati and Sturzenegger (2004) shows that the overall reasons for controlling the stability of an economy are one, to improve customers’ confidence in the international market. Two is that a stable economy encourages investment from foreigners who fear a floating exchange rate system. Finally a stable economy stimulates economic growth as well as business growth therefore maintained inflation rates. Conclusion In the recent world which is characterized by globalization and increase in technology, the old economic variables have been replaced. International trade has increased as a result of globalization and developed communication systems. This shows that the fixed exchange rate system is losing its advantages in the economic market. As the ties between countries increase, the government monetary and fiscal policies increase therefore more economies prefer liberation of financial markets since it improves financial risks such as instability therefore promising long term benefits in future. Most economies prefer using the floating exchange rate system since it offers better business opportunities in the future than the fixed exchange rate system. References Calvo, G & Reinhart, C 2002, Fear of floating, Quarterly Journal of Economics, vol. 117, no. 2, pp. 379-408. Dale, H 2002, The role of intervention policy in open economy financial policy, A macroeconomic perspective, International Finance Discussion Papers, London. Dixit, A 1999, Hysteresis, import penetration and exchange-rate pass-through, Quarterly Journal of Economics, vol. 104, pp. 20-28. Dornbusch, R 2000, Expectations and exchange rate dynamics. Journal of Political Economy, vol. 84, pp. 61-76. Friedman, M 1993, The case for flexible exchange rates, Essays in positive economics, University of Chicago Press, Chicago. Hansen, L & Robert, H 1999, Forward exchange rates as optimal predictors of future spot rates, Journal of Political Economy, vol. 88, no. 7, pp. 29-53. Krugman, P 2005, Is the strong dollar sustainable? In federal reserve Bank of Kansas City, Prospects and Policy Options. Lawrence, Z 2000, U.S. current account adjustment, Brookings papers on economic activity, vol. 5, no. 2, pp. 34-92. Marris, S 1995, Deficits and the Dollar, The world economy at risk, U.S.A. Marston, R 2000, Pricing to market in Japanese manufacturing, Journal of International Economics, vol. 29, no. 5, pp. 27-36. Levy-Yeyati, E & Sturzenegger, F 2004, Classifying exchange rate regimes, European Economic Review. vol. 24, no. 2, pp. 129 – 150. Matthew, B 1992, Exchange intervention policy in a multiple country world, Journal of International Economics, Elsevier, vol. 13, no. pp. 267-289. Read More