Fixed and Floating Exchange Rates - Coursework Example

INTERNATION BUSINESS: FIXED AND FLOATING EXCHANGE RATES (word count 2012) INTRODUCTION The question whether a country should decide on adopting a flexible or fixed exchange rate is one of the major policy concerns of any economy. Many countries have either encountered crisis that interrupted their growth because they made a wrong choice or because of misguided decisions others have not experienced growth. However, this is not to say that exchange rate policy is the only thing that counts, but distorting exchange rate policy could affect the entire economy negatively. FIXED AND FLOATING EXCHANGE RATES According to Summers one of the fundamental propositions in recent studies on exchange rate regimes, is that under free capital mobility, the exchange rate regime determines the ability to undertake independent monetary policy. A fixed regime implies giving up monetary independence while a floating regime allows for a national monetary policy. (Summers 2000) According to CRS Report Congress, floating exchange rate lets the market dynamics to determine the exchange rate. In states that permit their exchange rates regime to float the central bank intervenes regularly to limit short-term exchange rate fluctuations in a bid to control inflation. Almost all advanced economies and most large emerging market countries have floating exchange rate systems in place. Floating exchange rates offers countries an opportunity to make central banks independent in making monetary policies. Through financial instruments the central bank hedges out the risks posed by fluctuating exchange rates for this to be effective the financial markets have to strong enough to withstand shocks without large exchange rate intervention to make these monetary policies effective. In a pure fixed exchange rate regime, the central bank buys or sells any amount of currency at a predetermined rate. That rate may be linked to one or more foreign currencies. Countries where capital is perfectly dynamic investors consider all other countries alike, theoretically fixed exchange rates would necessarily be functionally equivalent to a currency board. Any unilaterally attempt to influences interest rates, through monetary or fiscal policy, would be unsustainable because capital would flow in or out of the country until interest rates has returned to the worldwide level. (CRS Report Congress 2004) BENEFITS AND COST OF FIXED AND FLOATING EXCHANGE RATES According to Eichengreen and group, floating exchange rates usually targets to control inflation, though there are answered concerns of business investors as to whether the monetary policies that target inflation do work in a freely floating exchange rate and how effective it is in promoting business investments in many developing and transition economies. These countries are subject to substantial amount of internal and external shocks and the transfer methods through which monetary policy affects the economy and the price level tend to be unpredictable and reliable. (Eichengreen et al 1998) Friedman suggested that flexible exchange rates help protect the economy against shocks. Evidence indicates that floating exchange rates could be quite volatile leading to uncertainty about future profits in the traded-goods industries. This makes firms hold on before hiring new workers, when demand is high and firing existing ones when demand is low. (Friedman 1953) As indicated by Barro and group, a fixed exchange rates aids international capital flows. In theory, capital importers and capital exporters’ balances currency differences, but in practice, risks and transaction costs intervene. Under fixed exchange rates, there is a diversion of monetary policy and dealing with the balance of payments. After a decline in demand, the crisis may last until wages and some other automatic mechanism of adjustment takes hold, prices come down or the government intervenes. (Barro and Gordon 1983) Current studies regarding fixed exchange rate partially based on the effect that large devaluations tend to have on firms’ balance sheets and on the banking sector. (Calvo 2000) As Mundell indicated, for over a long period of time, the country with a financially integrated economy faces a choice between autonomy of monetary policy or a fixed exchange rate. (Mundell 1963) If the country chooses a fixed rate, there are two possibilities that may happen in such an economy. First, if the country devalues its currency before fixing it this will have positive effect on its domestic business environment because this will promote the use of locally sourced products and services. Hence the local business will increase their sells and make profits which in turn will promote more local investments. Secondly if the currency is appreciates before fixing exchange rate, the export of goods and services from such a country increases, because maintaining a strong currency encourages companies to investment more on exporting goods and services hence promoting international business. These constraints of fixed exchange rates will either promote international business or discourage it, therefore, it depends on the kind of approach or what the country wants to achieve, there are those countries which, could prefer to be export oriented through keeping their currency devalued in away to encourage exports, in the recent past, countries which favour export through currency manipulation, tend to have more multinational companies setting shop or outsourcing from these countries. While those countries who fix their currency in such a way their currency is too much depreciated, they create a disproportion, in the sense that, those companies engaged in export loose out in when converting the pegged currency to local unit. This scenario reduces the chances of direct foreign investment in that country, and most of multinational companies will close down and move out of the country hence such a country’s loose revenues from these companies and the resultant foreign currency. (Kyland and Pagano 1977) Theoretically, fixed exchange rate presupposes that policy is made on welfare grounds and to promote foreign investment in the country using such a monetary policy. Countries use fixed exchange rates to encourage exports and direct foreign investments, thereby many local and multinationals companies take advance of this policy to do invest and do business within such a country hence benefiting the country through increased surplus of foreign currency reserves. (Cavan and Tommasi 1997) As Jeffrey suggests, the cost of fixed exchange rates is an externality and cannot be hedged away. The society bears some of the costs of fixed exchange rate regimes, so that market participants do not incur that cost in their transactions. The cost that society bears is threefold. First, to the extent that a country faces unique challenges, it gives up the ability to protect its economy against these shocks. The participants of international trade and investment do not compensate society for the fact that there is an increase of volatility of aggregate unemployment and inflation. Secondly, fixed exchange rate regime is more prone to crisis, which further increases the probability of high unemployment episodes. Even if the floating exchange rates were to lead to less growth they dampen the growth of trade and the foreign investment risk averse individuals prefer that the outcome if it leads to fewer crises. Thirdly, in some historical instances, fixed exchange rates have weakened the banking system through their incentives to share the debt that would not be repaid in the course of devaluation. Of the three factors, the rather is the only one that could theoretically be rectified through regulation, although implementing such regulation in practice could be difficult. When countries economies are interdependent enough, the benefits of fixed exchange rates outweigh the costs: countries’ experience fewer unique challenges, labour mobility improves, product markets may benefit from greater competition and economies of scale, and capital market integration increases. But few countries meet this criterion. (Jeffrey 2012) According to Blundell-Wignall and Gregory the authorities tried to accommodate terms-of-trade shocks through occasional realignments of exchange rate under the fixed exchange rate regime. However, the exchange rate did not effectively buffer the fluctuation of trade. While under the floating regime the exchange rate has been more effective in countering the effects of terms-of-trade movements, hence assisted in maintenance of internal balance. A case in point is of a rise in the commodity prices due to improved terms of trade. This rise of prices and trade provides an expansionary impulse to the economy through an increase in income, while there is increase of inflation resulting from increase of demand for inputs from the export sector. An appreciation of the exchange rate neutralises these influences to some extent by inducing a substitution of imported goods and services for domestically produced goods and services, and it puts downward pressure on inflation. Therefore, the nominal exchange rate appreciation induces the necessary appreciation of the real exchange rate to restore internal balance following the terms-of-trade shock. Under the fixed exchange regime the real appreciation comes from a rise in inflation unless there is an adjustment in the exchange rate peg. (Blundell-Wignall and Gregory 1990) DO INTERNATIONAL BUSINESSES PREFER A FIXED OR FLOATING EXCHANGE RATE SYSTEM? According to Pitchford developed countries usually rely on export to maintain a balance of trade by generating enough foreign reserves to cover their import quotas, and for a period of time they have developed a preference to floating exchange rate. These countries do have huge commodities to export therefore. They are affected by wide currency variations, which in turn affect the amount of money firms invest in those countries. However, floating rate is preferable in theory and has worked well in practice for international businesses, but in the actual terms there is no single country that keeps a perfectly floating system because of domestic politics which determines what direction the country takes in term of encouraging business investments and job creation. Theoretically floating exchange regime is good for those businesses that have a long term plan of investing and operating for quite a long term because the stabilization of exchange rates it balances itself after a period of time that favours multinational companies. Inflation is major concern for those countries who favour floating exchange rate, those investors especially involves in stocks, treasury bills or government bond, make looses if the is high inflation and their investment portfolio is for a short term. And those who invest for a long term do benefit because inflation do stabilize over time, therefore discouraging majority of small time investors. (Pitchford 1985) International business integration results in an increase of exposure to direct foreign investment which causes a lot of concerns to those engaged in or exposed to international trade. In a relatively closed economy, few business investors care about currency movements as most of them operate domestically and not exposed to global trade and finance. In a country with an open economy, the major benefit of a fixed exchange rate is to lower cost of doing business and transaction costs associated with international trade and investment with an aim of promoting investments in the country. (Kenen 1969) Additionally, recent analyses of countries with fixed exchange rate emphasize that an exchange rate peg can enhance monetary-policy credibility. Both evidence and theory suggest that fixed exchange rate to the currency of a low-inflation country both promotes international trade and investment and encourages export of goods and services by providing a stable exchange rate that favours exports. While a flexible exchange rate cause’s anxiety among international businesses because they are unable to plan for a long term without factoring in the rate of inflation in an economy. (Rose 2000) CONCLUSION At the current global trend, most countries are now in favour of floating exchange rates because it provides stability of long term business investments and international trade. However, exchange rate variations causes inertia in the international business investment by increasing the cost of operation, it reduces the number of entry of new businesses to the economy, particularly the high-risk ventures and hence reducing new investments. Fixed exchange rate regimes preferred for their high labour supply elasticity’s and creation of domestic demand which, derives up the prices of locally produced goods which in turn results in an increased investment on local companies. A fixed exchange rate has the advantage of promoting international trade and investment by encouraging more investment from domestic investors. Fixed exchange rate regimes prone to crisis because investors are compelled to remove their money from a country before it devalues. REFERENCE LIST Barro R and Gordon D (1983) monetary policy in a natural rate model positive theory. J Pol Econ 91(4), p 589–610. Bahmani-Oskooee M, Kutan A and Hegerty S (2008) Evidence from 89 countries do devaluations lead to real devaluations. Econ Finance Int Rev; 17, p 644–670. Blundell-Wignall A and Gregory R (1990) “Countries with advanced commodity-exports. Australia and New Zealand case study”, OECD Working Paper, no 83. Calvo and Guillermo A (2000) “Exchange Rate with Dollarization debate in Latin America Capital Markets” Maryland University. Canavan C and M Tomassi (1997) “On the Credibility of Alternative Exchange Rate Regimes,” Journal Development Economics, 54, p 101–122. Kenen P (1969) Theory of Optimum Currency Areas. International Economy Monetary Problems. Chicago University Press. Kydland F E and E C Prescott (1977) Inconsistency of Optimal Plans, Journal of Political Economy, 85, p 473–492. Eichengreen, Paul M and Barry J (1998) “Policy Options for Exit Strategies for States looking for Exchange Rate Flexibility.” IMF Occasional Paper no 168. Jeffrey A F (2012) Choosing an Exchange Rate Regime 2, p 767 Milton and Friedman, (1953) “The Case for Flexible Exchange Rates,” Positive Economics Essays, Chicago University Press. Mundell, Robert A. 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