What Fixed and Floating Exchange Rates Are - Case Study Example

Student No: Explain what fixed and floating exchange rates are. What are the costs and benefits of a fixed and floating exchange rate? With this in mind do international businesses prefer a fixed or floating exchange rate system? Word count: 2095 Introduction An exchange rate refers to the amount of one currency that would have to be paid to receive one unit of another currency. International transactions involving the exchange of goods, assets or services require exchange of currencies since those who sell generally want to receive payment in their own currency. This exchange of currencies is determined by the exchange rate regime adopted by a particular country. There are two common types of exchange rate regimes: fixed exchange rate and floating exchange rate. This paper will explain the two types of exchange rates and evaluate their costs and benefits. Based on the analysis, the paper will indicate the exchange rate regime that is preferred by international businesses. Definitions of fixed and floating exchange rates A fixed exchange rate regime is one in which the value of a one country’s currency is tied or pegged (sometimes loosely) to the value of some other currency (Daly & Farley 2010, p. 391; Vargas-Silva 2010, p. 431). This means that in such an exchange rate regime, the price of one currency is fixed vis-à-vis all other currencies by government authorities (Megginson & Smart 2008, p. 729). Under the fixed exchange rate system, governments peg or fix their currency’s value, usually in reference to another currency such as the US dollar. For instance, between 1994 and 2004, the Chinese renminbi was fixed to the dollar at a ratio of about 8.3:1; implying that the People’s Bank of China would sell any number of dollars that anyone wanted for at a rate of 8.3 renminbi per dollar (Daly & Farley 2010, p. 391). It is evident from this example that the central bank needed to have foreign currency at hand to facilitate this exchange. This currency would be derived from the demand for Chinese products. On the other hand, a floating exchange rate is a system whereby the exchange rate is determined by international supply and demand for currencies, or in other words, market forces (Daly & Farley 2010, p. 392; Megginson & Smart 2008, p. 729). In this case, as opposed to the fixed exchange rate system where central banks peg the value of one currency to another, the central bank plays no direct role in determining how the rate of exchange of currencies changes. In the floating exchange rate regime, currencies are left to float freely and their values are established by demand and supply in the foreign exchange market (Vargas-Silva 2010, p. 432). In this case, the only currency which is available for buying goods, assets or services is that which foreigners use on the purchase of domestic goods, assets and services. If the demand for foreign currency is higher than the supply, its price will increase, implying that the national currency depreciates. On the flip side, when the demand for foreign currency is lower than the supply of the same, the national currency appreciates (Daly & Farley 2010, p. 392). As noted, the demand for and supply of the foreign currency determine the exchange rate under a fixed exchange rate system. Costs and benefits of fixed and floating exchange rates Benefits and costs of a fixed exchange rate The benefits of a fixed exchange rate can be categorised into two broad groups: that a fixed exchange rate stabilises the local currency and that a fixed exchange rate system can act as an effective nominal anchor for fiscal policy (Frankel 1997, p. 40). Beginning with the first point, it has been argued that a fixed exchange rate stabilises currency and thus reduces the uncertainty about exchange rate among exporters and importers (Frankel 1997, p. 40). On top of that, when the exchange rate is fixed, international lenders and borrowers can rest assured that their transactions will take place at a given known rate and this reduces unexpected losses that would occur if the currency were to fluctuate in value. Arnold (2008, p. 466) argues that this reassuring aspect of fixed exchange rates can promote international trade, whereas flexible exchange rates will stifle it. In the same scope, Vargas-Silva (2010, p. 432) points out that by fixing the value of the domestic currency in relation to that of a major economy, a nation can reduce exchange rate unpredictability and thus promote trade and investment. The second benefit of a fixed exchange regime as mentioned has to do with the pegged rate serving as a nominal anchor for monetary policy, which can lead to price stability (Frankel 1997, p. 40). For example, a fixed rate regime is straightforward and easily understood by the general public. If the regime is credible, implying that the public has confidence that the authorities will pursue a given rate, then it may reduce inflation expectations to the level prevailing in the anchor country (Vargas-Silva 2010, p. 432). Some countries (mostly developing ones) go to the extent of surrendering their monetary policy when their economies lack the discipline and incentives to create revenue from money creation. For instance, in 2009, Zimbabwe adopted dollarization (the use of another country’s currency as the sole legal tender) in February 2009 following the introduction of a multiple currency regime, with the rand of South Africa being used as the reference currency for accounting purposes (Kanyenze & Kondo 2011, p. 50; Vargas-Silva 2010, p. 432). Dollarization was introduced because of the lack of confidence in the domestic currency due to chronic inflation, currency rises and absence of credible fiscal policy. When dollarization was introduced, it had the immediate impact of eliminating hyperinflation, which resulted in an improvement in the business climate and economic stability of Zimbabwe (Kanyenze & Kondo 2011, p. 50-51). The costs of using a fixed exchange rate system are related to the point that the government has to sacrifice other policy objectives in order to sustain the regime. For example, if the exchange rate is under downward pressure, the government may increase the interest rate, which could slow down economic growth and cause a spill-over effect such as unemployment. Additionally, there is no guarantee that the set rate will be at the long-term equilibrium level. If the level is too high, this puts firms at a competitive disadvantage because exports become relatively highly priced whereas imports are very cheap. In such a case the rate would not be sustainable, and the value of the local currency would ultimately have to be reduced. Further, the country exercising a fixed exchange system must keep reserves of the foreign currency in case the central bank has to intervene to increase demand for the currency. This is a risky situation as the foreign currency could as well be put to other uses (Grant & Vidler 2000, p. 283). Given the problems stated above, maintaining a currency peg can be quite difficult. For instance, in response to rising economic problems, the Argentine government allowed the peso, which had been pegged to the US dollar, to float freely for the first time in ten years on 11 January 2002, and a day later, the peso depreciated by 40 percent relative to the dollar (Megginson & Smart 2008, p. 729-730). Benefits and costs of a floating exchange rate The benefits of the a floating exchange rate system stem from the point that this regime offers monetary policy autonomy since the central bank is not required to get involved in the foreign exchange market to maintain a given value for the currency and insulation from external shocks (Vargas-Silva 2010, p. 432). It is therefore possible that with a floating exchange rate regime, changes in wage levels, inflation, and employment in one country do not spill over into another country as they do in a fixed exchange system (Butler 2012, p. 28). With a fixed exchange rate, consumers in one country are likely to gain when value of their currency increases relative to that of the country from which they are importing; while this situation does not favour the country whose currency is weak. But with a floating exchange rate system, it is possible for the economy to adjust to a differential inflation, and this allows a single worldwide price for commodities or services from all countries. A floating rate system also tends to insulate the domestic economy from changes in wage levels, inflation, and employment in other countries (Butler 2012, p. 28). The main disadvantage of the floating exchange rate system is that flexible exchange rates are always associated with destabilising speculation (Vargas-Silva 2010, p. 432). Since the exchange rate varies continuously, it is often difficult to determine how much cash flow in a foreign currency will be equivalent to the domestic currency. This causes uncertainty as traders remain unsure how much the currency they are holding will be worth in the future (Butler 2012, p. 28; Grant & Vidler 2000, p. 283). Because of the speculation involved, some traders may seek to offset their uncertainty by agreeing on a price in advance but this involves a cost. For instance, if a Kenya signs a contract for the construction of a road with a US company and agrees to pay the company in US dollars, the country may have to pay more if the exchange rate shifts from say 80 Kenya shillings per dollar to 90 shillings per dollar at the time the payment is made. Preferred exchange rate system There is no doubt that businesses would like to know the exchange rate when making trading decisions (Glanville & Glanville 2011, p. 377). If this is the case, then it would not be wrong to say that businesses prefer a fixed exchange rate system. However, a theory put forward by Jeffry Frieden (1991 & 1994, cited by Hall 2005, p. 26) can help to show how different interest groups perceive exchange rates. According to Frieden, exporters and global investors have a strong interest in the stability of exchange rates since instability in exchange rates exposes their business to risk. Moreover, industries that have a foreign focus can shift their business abroad when the local economy suffers, and hence they do not need to depend on macroeconomic stimulation to deal with local downturns. Such exporters and international investors would prefer some form of fixed exchange rates (Hall 2005, p. 26). Frieden further notes that for industries that create goods or services for domestic consumption, the reverse is true. This is because producers for the local market and industries that compete against imports have little interest in the stability of exchange rates, but would be interested in a fiscal policy that can stimulate the economy during a slump. Thus, they would be interested in some form of floating exchange rates (Hall 2005, p. 26). In subsequent work with Ernesto Stein however, Frieden introduces a point of caution with regard to the above theory (Hall 2005, p. 26). They note that for countries in which the total of imports and exports is over 100 per cent of GDP, such as in many Caribbean nations, economic agents are subjected to significant risk and fixed exchange rates are common (Hall 2005, p. 27). However, in many Latin American nations, the adoption of fixed exchange rates has led to an appreciation of the real exchange rate, which hurts the competiveness of producers of tradables. Therefore, Frieden and Stein argue that the more powerful tradables producers are, the higher the probability that the government will adopt a float that can permit the exchange rate to depreciate (Hall 2005, p. 27). Conclusion A fixed exchange rate system is one in which the value of one nation’s currency is pegged to the value of some other currency while a floating exchange rate regime is one whereby the exchange rate is determined by international market forces. There are two major benefits of a fixed exchange rate in that the system stabilises the local currency and can act as a useful nominal anchor for monetary policy, which leads to price stability. However, with this system, the government has to sacrifice other policy objectives as it actively monitors the exchange rate. The reverse is true for the floating exchange rate since the central bank is not required to engage actively in the foreign exchange market to insulate the country from external shocks. But floating rates are always associated with destabilising speculation, which may reduce international trade. From the discussion, it can be argued that international businesses would prefer a fixed exchange rate for decision-making purposes. However, Frieden’s theory suggests that exporters and international investors would prefer some form of fixed exchange rates while producers for the local market and industries would prefer some form of floating exchange rates. References Arnold, R A 2008, Microeconomics, 9th edn, Cengage Learning, New York. Butler, K 2012, Multinational finance: Evaluating opportunities, costs, and risks of operations, 5th edn, John Wiley & Sons, New York. Daly, H E & Farley, J 2010, Ecological economics, second edition: Principles and applications, 2nd edn, Island Press, Washington DC. Frankel, J A 1997 ‘Monetary regime choice for a semi-open country’, In Edwards, S (ed), Capital controls, exchange rates, and monetary policy in the world economy, Cambridge University Press, Cambridge. Chapter v, pp. 35-70. Glanville, A & Glanville J 2011, Economics from a global perspective, 3rd edn, Glanville Books, London. Grant, S & Vidler, C 2000, Economics in context, Heinemann, London. Hall, M G 2005, Exchange rate crises in developing countries: The political role of the banking sector, Ashgate Publishing, Ltd., London. Kanyenze, G & Kondo, T 2011, Beyond the enclave: Towards a pro-poor and inclusive development strategy for Zimbabwe, African Books Collective, Oxford. Megginson, W L & Smart, S B 2008, Introduction to corporate finance, 2nd edn, Cengage Learning, New York. Vargas-Silva, C 2010, ‘Exchange rates’, In Free, R C, 21st Century economics: A reference handbook, volume 1, Sage, London. Chapter 42, pp. 431- 439. Read More