Advantages and Disadvantages of Operating a Floating Exchange Rate Regime - Essay Example

Advantages and Disadvantages of Operating a Floating Exchange Rate Regime Introduction There are roughly three main categories of exchange rate systems employed by various countries in their respective economies. Flexible or floating exchange rate system, fixed exchange rate system and managed floating exchange system. In a system, of fixed exchange rate, the government intervenes in the currency market through the central bank; the exchange rate is fixed for it to stay close to a predetermined exchange rate target. The motivation behind maintaining a fixed exchange rate is the trust that a stable exchange rate will assist in facilitating trade and investment flows among countries by reducing relative prices fluctuations and by reducing uncertainty (Karl 2010, p.181). In a floating exchange rate system, the market forces determine the value of the currency; that is, by the interactions of several of banks, firms and other institutions seeking to sell and buy currency for the purposes of clearing transactions, arbitrage, hedging, and speculation. In October 1990, the UK joined the European Exchange Rate Mechanism (ERM), where the Sterling Pound was fixed against other currencies. In September 1992, UK left the ERM when the pound experienced sustained selling pressure, and the monetary authorities could no longer justify extremely high interest rates to maintain the value of the pound, when the domestic economy was under a deep recession. Since 1992, UK has adopted a flexible exchange rate system; there is no official intervention by the Bank of England to the currency markets to attain the desired level of exchange rate (Roderick & Paul 2004, p.143). Advantages of a Floating Exchange Rate The following are the key arguments in favor of a flexible exchange rate. First, reduced necessity for currency reserves; there is no target for an exchange rate level meaning there is little necessity for the Bank of England to hold large scale reserves of foreign currency and gold to use in possible official intervention, in the currency markets. However, in the real world, for example, in UK, the government always has some currency reserves, in case of balance of payments crisis, or the sentiment that the Sterling Pound is getting a bit too low or too high (Karl 2010, p.182). Second, useful tool of macroeconomic adjustment; a floating exchange rate may act as a useful instrument of macroeconomic adjustment. For example, depreciation of the currency should provide a boost in demand of net exports and thereby stimulate growth. This assumes that the higher wage claims or export prices do not dissolve the achievements from a low exchange rate as noted by Susan 2000, p.283. For example, countries in the Euro Zone may be anticipating for a more competitive rate of exchange as a way of generating an injection of demand into their slow growing economies. From 1996-2006, the United Kingdom flourished, with unemployment rates falling, household spending rising, but the rates of interests were also rising. During this period, there was undervaluation of the Sterling Pound, and speculators were willing to purchase Sterling Pound (Andrew 2007, p.399). Third, partial automatic adjustment for a trade deficit; flexible exchange rates offer a degree of correction when the balance of payments is in fundamental disequilibrium. A large trade deficit exerts downward pressure on the rate of exchange that should help the export sector and manage demand imports, since they become relatively expensive. However, in the real world, for example, in UK, floating exchange rate does not always eliminate trade imbalances since so few currency transactions are entirely for trade purposes (Susan 2000, p.285). Fourth, the floating exchange rate reduces the risk of currency speculation; the absence of a precise exchange rate target diminishes the risk of currency speculation. Frequently, speculators in the currency market target a rate of exchange that they believe it is essentially under or overvalued. In the late 1970s and early 1980s, various European countries attempted to use capital controls to prevent speculative pressures, it came clear that the cost of attaining fixed exchange rate outweighed the benefits. This observation, in addition to ERM crises, in the early 1990s, provided some momentum for the adoption of the floating exchange rate in UK in September 1992. From 1992 to date the floating exchange rate in UK has reduced the speculative pressures (Roderick & Paul 2004, p.145). Fifth, freedom or autonomy for domestic monetary policy; the absence of a predetermined exchange rate permits setting of short term interest rates to meet domestic macroeconomic goals such as controlling inflation and stabilizing growth. Since its independence in May 1997, the Bank of England has enjoyed the autonomy arising from the floating exchange rate. The evidence of the past twenty years in the UK economy shows that even though exporters suffer when the pound is strong, the entire economy is best served when the monetary authorities can manage domestic monetary policy. Sixth, flexible exchange rates are not always volatile exchange rates; despite the floating nature of the sterling exchange rate, the volatility has not been great. Most businesses have found means of coping with modest fluctuations with the help of flexible labor market. Before the adoption of the floating exchange, the Sterling Pound experienced depreciation in the preceding months before September 1992. After the adoption of floating exchange rate, the Sterling Pound appreciated at a slower rate, at an average of 90.0 exchange rate index (Susan 2000, p.284). Disadvantages of Floating Exchange Rate System The following are the disadvantages of employing a floating exchange rate system in an economy. First, uncertainty; that fact that there are daily changes in the currency values introduces uncertainty or instability into trade. Traders may be unconfident of how much money they will obtain if they sell their commodities abroad. Similarly, importers will be uncertain on how much it will cost to import a given amount of foreign commodities. Daily fluctuations of the exchange rate will affect the price and sales of exports and imports. This uncertainty can be minimized by hedging the foreign exchange peril on the forward market. For example, UK has been experiencing changes in growth of exports since the adoption of the floating exchange rate system. For the last twenty years, the fluctuations of the exchange rate have influenced the competitiveness of the UK based export industries in the international markets. When there is a higher exchange rate, exporters experience difficulties while selling in foreign markets because of the increase in relative UK prices (Andrew 2007, p.402). Second, lack of investment; the uncertainty may lead to little investment both internally as well as from abroad. Third, speculation; there will be inherent speculation in a floating exchange rate system and it may be destabilizing and damaging for the economy. The reason is that the speculation flows may frequently differ from the underlying nature of trade flows. One might argue that, with flexible exchange rates, there will be less speculation since an exchange rate can freely move down and up, so there is a high probability the exchange will be in its stable equilibrium. As in the UK case, the fact is that the exchange rate moves up and down; this means that it can move a long way if the speculators believe that the rate is at the incorrect level. In the second half, of 1996 the value of the pound experienced a rapid appreciation, and this showed that fluctuations of currencies are not only caused by forces from speculators (Kevin 2011, p.666). Fourth, lack of discipline in the management of the economy; if inflation is not checked there is a risk that governments will follow inflationary economic policies. These policies result to a problematic level of inflation. Presence of a predetermined inflation rate helps in overcoming these problems caused by inflationary economic policies. The experience of the UK indicates that a flexible exchange rate probably is not an automatic cure of the balance of payments deficit. Correction of the balance of payments deficit depends on the price elasticity of demand for exports and imports. Kevin 2011 p.668 explain the Marshall-Lerner condition which indicates that, exchange rate depreciation will help in improving the balance of payments, provided that the sum of the price elasticities of imports and exports is greater than one. Floating exchange rate does not exert discipline on domestic companies and employees, so that they can control their costs in order for the economy to remain competitive in global markets. Fifth, inflation; the floating exchange rate may be inflationary. The market determined exchange rate can cause inflation by allowing prices of imports to rise as the exchange rate falls. This is the case in UK where the country is dependent on raw materials imports and food imports (Susan 2000, p.285). In year 2011, the UK Monetary Policy Committee was under pressure to increase the rate of interest with an aim of controlling the inflation that the country was experiencing. At the time, the rate of inflation was double the Monetary Policy Committee target of 2%. The rate of inflation was above the target for sixteen consecutive months. The high rate of inflation was attributed to successive increase in VAT and the unfavorable fluctuations in global commodity prices. The fluctuations of the commodity prices were large; since summer 2010, tin and wheat prices doubled, cotton prices trebled while the price of copper increased by 60%. Though the increase in commodity prices was absorbed along the supply chain, their impact was clearly apparent on the retail prices. For example, in the first quarter of 2011 the food and non-alcoholic drinks constituent of the CPI increased by 5.7% compared to an average of 2.9% a year over the previous decade. The UK imports experienced an increase in prices and the increase was credited to changes in the international commodity prices which are influenced by the exchange rate. UK could have not intervened in the currency market, due to its floating exchange rate monetary policy. Therefore, the Monetary Policy Committee was left with the option of altering the interest rate, so as to control the inflation (Oxford Economic Limited). References Andrew, G. 2007, Foundations of Economics, Oxford University Press, Oxford. P.399-428. Karl, G.P. 2010, An Economic History of Europe: Knowledge, Institutions and Growth, 1600 to the Present, Cambridge University Press, Cambridge. p.181-220. Kevin, D.H. 2011, Applied Intermediate Macroeconomics, Cambridge University Press, Cambridge. p.666-700. Oxford Economics Ltd., 2011, Economic Outlook: Should the MPC Increase the Interest Rates? Oxford Economics Ltd., London. Available at: http://www.oef.com/OE_FA_Display_Frm.asp?Pg=UKSpec&Txt=UK%20Economics%20Services# 27th March 2012. Roderick, F. & Paul, A.J. 2004, The Cambridge Economic History of Modern Britain, Volume 3, Cambridge University Press, Cambridge. p.140-180. Susan, G. & Chris, V. 2000, Economics in Context, Hienemann, London. p.283-320. Read More