The Problems Associated with a Fixed Exchange Rate - Essay Example

section/# The Economics of High Inflation and the Problems Associated with a Fixed Exchange Rate Scholars have noted that “High inflation countries often attempt to achieve a reduction in their inflation rates by pegging their currencies to those of low inflation countries”. As a function of this dynamic, the following discussion will seek to represent some of the more notable problems that exist with respect to pegging or fixing a currency to another; a strategy that is often pursued by economically disadvantaged nations that experience high rates of domestic inflation. Developing countries face a litany of different challenges. But one of the most salient challenges has to do with the way in which currency is valued, exchanged, and impacts upon trade. Ultimately, before a policy of trade engagement can effectively be promoted, a country will necessarily find it impossible to do so without first engaging with the issue of currency valuation. Many nations within the developing world face a situation in which rampant inflation defines their currency and ultimately restricts the level and extent to which they can engage in trade. One of the means by which this extremely high inflation is often reduced if I continue to fix the exchange rate (also known as pegging) to a currency of a low inflation country. For practical intents and purposes, almost all currencies that are pegged are fixed to the United States dollar; the international unit of monetary exchange for most trade. Yet, as with any economic decision, there are drawbacks and benefits to the way in which a fixed exchange rate impacts upon the economy in question. As a function of seeking to understand this dynamic to a more full and complete degree, the following assessment will provide a detailed discussion of how these drawbacks and benefits affect nations that attempt to reduce their overall rates of inflation by fixing their currencies to another. Through such a unit of discussion, it is the hope of this author that the reader will gain a more informed and relevant understanding of how the decision-making structure to fix a currency must be cognizant of the broader ramifications of such a policy would necessarily entail. One of the main reasons that currencies are fixed to an outside currency has to do with the fact that continual fluctuations within a domestic currency and create a dynamic by which trade is almost impossible. For instance, even if a developing nation has a certain set of commodities that are in high demand and that are certain to sell in the global marketplace, the pricing of these commodities will continually fluctuate within a dynamic in which high inflation defines the monetary outlook for the nation in question. Likewise, if a firm that was exporting a given good saw a situation in which drastic and rapid inflation defined the day to day business climate, potential earnings of the goods and services sold on a global market would be significantly decrease; due to the fact that a given unit of currency and/or price would move against one another and create a dynamic by which the ultimate benefit for the firm or the nation in question would drastically be reduced. From an alternate perspective, the reader can adequately note that a rapid devaluation and domestic currency would also create a situation in which imports would become exorbitantly more expensive (Boschee, 2006). Similarly, a fixed exchange rate also creates a more stable platform through which investment can be encouraged. The day to day uncertainty that price fluctuations and currency devaluation can have is almost certain to make the process of doing business next to impossible; and tangentially reduce the overall incentive for domestic investment as outside entities, as well as domestic business owners will be reticent to invest in existing potential for fear that their investment could be negated as a result of rampant inflation. As indicated within the introduction, there are an array of difficulties and issues that arise when nations attempt to fix their exchange rate to another and pursue this particular monetary strategy. Within such an understanding, the following section will be contingent upon analyzing these disadvantages and discussing some of the potential reasons why they are exhibited. One of the most common disadvantages of pursuing a fixed monetary exchange rate has to do with the potential conflict with other objectives that this particular monetary policy impacts (O’Sullivan, 2012). The first and most obvious disadvantage that is exhibited with respect to conflicts with other objectives has to do with the overall level of reserves that a given monetary system might otherwise exhibit. For instance, in a situation in which a currency is not fixed to another, the fluctuation and inflation/appreciation or decrease she that takes effect oftentimes does not directly impact upon the overall foreign-currency reserves or asset that the nation in question might otherwise leverage (Grady, 2013). However, in a situation in which a fixed exchange rate is exhibited, it is required that the government or monetary institution in charge of finance must intervene if in fact the currency is falling beneath a certain preset band that such an institution has previously agreed-upon. As a means of intervening and ensuring that the currency remains within a given band, it will be necessary for the government or financial entity responsible for currency and exchange rates to purchase or sell sterling as a function of keeping the currency fixed within the specified band. A noted disadvantage that exists and tandem with this has to do with the fact that purchasing sterling or otherwise leveraging foreign currencies as a function of moving a domestic currency back into a specified band is only a short-term fix (Hefeker, 2012). As such, it can work for a brief period of time if the factors at hand are easily ameliorated. However, in the event that deeper economic issues are at play, a weakening of the system over time is all but inevitable. One can consider a case in which deeper economic issues play a given developing economy that has its currency fixed; thereby leading to a situation in which it leverages foreign assets and currencies/sterling to a greater and greater level over months and years (Sachs & Larrain, 2009). Eventually, the assets and sterling reserves that the given country exhibits is reduced to the point at which the nation itself is practically bankrupt and the rest of the monetary means by which it can continue to develop. This is of course a worst-case scenario; however, it is indicative of the way in which many nations find themselves playing by the destructive practice of seeking to fix their currency to another. In fact, such a policy is not much different than merely printing money; as it creates a situation in which the overall level that economy might otherwise exhibit is being decrease by the slow erosion of savings and foreign reserves. In the long run, a nation that experiences underlying economic hardships that could create a situation in which fixing its currency to another is untenable faces similar if not identical challenges as compared to one that faces extraordinarily high inflation and a non-fixed currency parameter. An ancillary problem that exists alongside the one which has already been discussed above has to do with the requirements of maintaining high levels of foreign currency reserves within a situation in which a fixed exchange rate is exhibited. Within a situation in which a country does not have a fixed exchange rate, the requirement to have a very high percentage of its overall asset held in foreign currencies is of course almost all but nonexistent. However, within a situation in which a nation has a fixed exchange rate, it becomes necessary to extend large amounts of money on accruing stockpiles of foreign currencies that can be exchanged in the eventuality that the currency falls beneath a given band (Katsimbris & Miller, 2005). This creates a financial hardship and constricts the overall level of investment and available monetary resources/asset than might otherwise be available for development in the eventuality that a country does not have a fixed exchange rate. Another noted disadvantage that nations face with respect to fixing their currency to an outside currency has to do with a restriction in the level of economic flexibility or monetary policy decision making freedom. In a country in which currently is not fixed, the central bank for governmental entity responsible for monetary policy can easily make major decisions and almost complete freedom. However, at the moment in which a currency is waits to another outside currency, it then becomes incumbent upon the central bank or government entity responsible for monetary policy to consider the ramifications to the fixed exchange rate that any change in policy could create. A prime example of this can be seen with respect to the way in which a given central bank might respond to temporary shocks within the market. As example, a nation that imports oil, or another such primary commodity, may face a balance of payments deficit in the eventuality that oil prices were to increase. However, in a fixed exchange rate situation, there is almost no chance to devalue the currency as a function of responding to this pressure. In effect, a fixed exchange rate ultimately limits the monetary policy options that are available to decision-makers with respect to the way in which they might respond to dynamic shift within the market or other unplanned/unexpected changes. Essentially, scholars have noted that one of the primary and fundamental drawbacks of a fixed exchange rate has to do with the reduction in choice that monetary policy faces as a result. Essentially, the primary monetary policy concern that a nation which does not have a fixed exchange rate faces is with respect to seeking to maximize the utility and purchasing power that their nation and people are able to exhibit. By means of contrast in comparison, a nation that exhibits a fixed monetary exchange or pegged currency is perennially concern first and foremost with ensuring that the domestic currency remains within a given band and does not deeply fluctuate from the values that have been preset. Another noted problem that exists for countries that seek to pursue such a monetary policy of fixing their exchange rate to another currency has to do with the fact that no nation is assured that they are joining a given currency agreement at the correct rate. Invariably, the decision to fix a currency to another is that I’m not at a time in which economic strength and prosperity is being exhibited; rather, it is done at a time in which difficulty and hardship with respect to rampant inflation is oftentimes the case. Because of this dynamic, nations that enter into an agreement of a fixed exchange rate are not within a bargaining position and cannot necessarily stipulate the way in which the agreement and monetary policy should be drafted. In effect, the urgency of the situation creates a high potential that a country might enter into a fixed exchange rate at the wrong rate. What is meant by this has to do with the potential that a nation in monetary distress has no way of knowing whether or not the currency to which they are pegging is overpriced at the time in which they choose to peg or whether they are making a choice of monetary value; in that the currency to which they are pegging might be undervalued. If the currency rate is too high at the moment in which a fix is agreed-upon and created, exports will be harmed due to the fact that they will be, uncompetitive on the global market. Likewise, even though it might seem as if establishing a currency fixed in a situation in which the current feedback is pegged to is undervalued might be a good thing, this too is negative; due to the fact that such a situation will cause inflation once again. A further noted problem that exists with respect to a fixed exchange rate has to do with the fact that it oftentimes leads to imbalances with the current accounts that a country keeps. In the event that an overvalued exchange rate creates a situation in which current accounts are likely to be in deficit. By means of contrast and comparison, this threat does not necessarily exist for nations that do not peg their currency to another. The final problem that will be discussed within this brief analysis pertaining to fixed exchange rates has to do with the fact that they are by very nature unstable. Individual nations with fixed exchange rate mechanisms invariably followed different economic policies. As a direct result of this, trends differ with respect to the way in which inflation is exhibited. This ultimately creates a situation in which best practices regarding how to ameliorate inflation and ensure that a given currency remains within the preset band that has been agreed upon is increasingly difficult; ultimately leading many currencies to become devalued over time and placing increased pressure on the central bank or government entity responsible for regulating monetary policy to continue to expand foreign reserves as a function of fighting continual inflation. For those developing countries that seek to pursue such a strategy, you are cognizant of the fact that the overall on competitiveness of their economies create a situation in which severe pressure is continually, if not invariably, placed upon the nation to devalue its currency in the face of ongoing economic challenges that faces. This dynamic creates a situation in which the nation that has chosen to pursue a fixed exchange rate finds itself in a situation in which is ultimately not better off economically as compared to if it had chosen to freely float its exchange rate and risk the internal and external ramifications of continual inflation and deflation. From the information that has thus far been represented, it is clear and apparent that choosing to pursue a monetary strategy of a fixed exchange rate portends a great many economic difficulties and potential hazards for a developing nation. With this in mind, it should not be the interpretation of the analyst that a fixed exchange rate is invariably a bad idea and one that creates even further economic hardships for each and every country that seeks to engage with. Instead, the broader understanding that should be realized has to do with the fact that a fixed exchange rate is not guaranteed to ameliorate the deeper and more complex economic hazards that a developing nation might be facing. Instead, it is necessary to review the underlying economic situation, balance of payments, current account, foreign currency reserves, and potential economic growth, not to mention the potential currency at which a fix is being considered prior to seeking to pursue such a strategy. The unfortunate fact of the matter is that almost all nations that pursue a fixed exchange rate ultimately do so as a function of the fact that they find themselves in dire economic straits that require immediate attention as a function of rescuing their economy of the brink of collapse. Instead, nations seek to pursue a fixed exchange rate should consider the ramifications and long-term impacts of this strategy prior to making a decision and in so doing ameliorate the potential for hardship that exists as a function of the specific problems that have been discussed at length in the analysis above. Bibliography Boschee, EM 2006, Floating exchange rates: The only viable solution, Region (10453369), 10, 3, p. 36, Academic Search Complete, EBSCOhost, viewed 20 August 2014. Grady, P 2013, Making free trade work by fixing the dollar, Canadian Business Review, 20, 2, p. 29, Academic Search Complete, EBSCOhost, viewed 20 August 2014. Hefeker, C 2012, SENSE AND NONSENSE OF FIXED EXCHANGE RATES: ON THEORIES AND CRISES, CATO Journal, 20, 2, p. 159, Academic Search Complete, EBSCOhost, viewed 20 August 2014. Katsimbris, G, & Miller, S 2005, Monetary policies of developed countries, Journal Of Economic Studies, 22, 2, p. 44, Academic Search Complete, EBSCOhost, viewed 20 August 2014. OSullivan, J 2012, Shadows Before Them, National Review, 14 December, Academic Search Complete, EBSCOhost, viewed 20 August 2014. Sachs, J, & Larrain, F 2009, Why Dollarization Is More Straitjacket Than Salvation, Foreign Policy, 116, p. 80, Academic Search Complete, EBSCOhost, viewed 20 August 2014. Read More