Fixed Exchange Rates and National Currencies - Essay Example

FIXED EXCHANGE RATES AND NATIONAL CURRENCIES By Student’s Name Code + Course Name Professor’s Name University Cite, State Date PART I International Financial System refers to a global framework that comprises of certain international financial institutions, official and unofficial international economic and finance actors, both governmental and non-governmental as well as legal arrangements and agreements among different international actors such as state actors, international institutions etc. The basis of the International Financial System is the facilitation of financial capital flow across different borders, regions and continents in the international stage, to ensure that state actors, as well as private business organizations and enterprises such as multinational corporations and other international institutions can smoothly finance their trading activities, as well as other business interests such as investments (Flandreau, Holtfrerich &James, 2003). Some of the important international actors in the International Financial System include the Bretton-Woods Institutions, i.e. the International Monetary Fund, the General Agreement on Tarriffs and Trade and the World Bank Group, which comprises of the International Bank for Reconstruction and Development (IBRD) and the International Development Assistance (IDA) both of which focus their operations on developing and underdeveloped countries, the International Finance Corporation (IFC), the International Centre for the Settlement of Investment Disputes (ICSID) and finally the Multilateral Investment Guarantee Agency (MIGA) (Melvin & Norrbin, 2013). Further important international actors in the International Financial System are the World Trade Organization as well as the European Monetary System that emerged after the formation of the European Union. Being the biggest monetary and fiscal union in the world, the European Monetary System has the unique ability of affecting the operations of the International Financial System. In the International Financial System, there are different types of monetary exchange rate systems used by different countries in the facilitation of monetary exchanges. The two main types of international monetary exchange rate systems are the Fixed Exchange Rate System and the Floating Exchange Rate System (Caramazza & Jahangir, 1998). It has been observed that most governments hold a high preference to the international monetary Fixed Exchange Rate Systems, and are therefore bound to utilize this system most of the time. On the other hand, it has also been observed that most private investors from different business enterprises and multinational corporations and organizations favor the international monetary Floating Exchange rate System. This report shall thereby look into the reasons why governments hold preference to the Fixed Exchange Rate System and why private investors usually favor the Floating Exchange Rate System (Uzan, 2005). 1. Why Governments Prefer Fixed Rate International Financial Exchange Rate Systems The international Monetary Fixed Exchange Rate System is a type of exchange regime whereby the rate at which the domestic currency of a given country’seconomy exchanges for foreign currency.This particular exchange rate is usually fixed by the Central Bank of a given country/federation or union. In this particular monetary exchange rate regime, the exchange rate may either be fixed at one particular rate or alternatively, the exchange rate can be allowed to fluctuate within certain specified narrow margins (). Some of the major reasons as to why many different governments hold a huge preference to the international monetary exchange system of the fixed exchange rates are; a) The fixed exchange rate system enables governments to make different plans dealing with trade and investments. This is because the fixed exchange rate system reduces any existing uncertainties about the values of exchangerates in the International Financial System, thereby making international trade and investment activities much more stable. As such, many governments prefer fixing their monetary exchange rates (Saccomanni, 2008). b) Governments also like using the fixed exchange rate system because it offers them a very good opportunity, if inflation arises in an economy, to fight it in a more firm manner. This is because of the nature of the fixed exchange rate regime, whereby inflation usually damages the balance of payments of a country in a much profound way. To avoid such scenarios, many governments always choose to fix their exchange rates in advance (Carbaugh, 2005). c) Governments also like using the international monetary fixed exchange rate regime because this particular regime forces countries faced with balance of payment deficits to undertake collective action. If it was in a floating exchange rate regime, the governments would be forced to simply rely on a change in the exchange rates, foreseeable or not. Therefore, in the event that agiven economy is faced with balance of payment deficits, a fixed exchange rate regime will allow the involved government to implement deflationary measures to remedy the balance of payment deficit (). 2. Why Private Investors Favor Floating Rate International Financial Exchange Systems The International Monetary Floating Exchange Rate Systems is a type of exchange rate regime whereby the rate at which the domestic currency of a given country, federation or union exchanges for foreign exchange. The floating exchange rate system is normally reliant on the forces of demand and supply in the International Financial and Monetary System. In this particular case, the equilibrium exchange rate that can be determined by this regime and the quantity too is the equilibrium quantity of the U.S Dollar that would be demanded and supplied(Suranovic, 2008).Some of the main reasons why most private investors favor the international monetary exchange system of the floating exchange rate regime are; a) The floating exchange rate regime normally leads to automatic stabilization of the exchange rates. This is because any balance of payment disequilibrium is able to be rectified through changing the exchange rate. For instance, if a given country is faced with a balance of payment deficit, a depreciation of the country’s currency should occur, making imports more expensive and exports cheaper. This would thus result into a balance of payment equilibrium, a scenario that highly favors private investors (Calvo & Reinhart, 2002). b)The floating exchange rate regime helps in the prevention of rapid inflation from damaging the exports of a particular country. For the private investors connected and/or operating in that particular country, only a floating exchange rate system would save them from the damaging effects of rapid inflation (Levy-Yeyati &Sturzenegger, 2005). c) The floating exchange rate regime further allows for a smooth, automatic and gradual adjustment of the exchange rate of a given country. Such an adjustment ensures that no sudden changes occurs regarding money and finances which may cause expectations from buyers and sellers.This provides private investors will ample room to carry out their investment activities(Calvo & Reinhart, 2002). d) The floating exchange rate regime creates an opportunity where countries only need to maintain lower foreign currency reserves needed to defend their domestic currencies. As such, foreign currency reserves can be productively employed elsewhere, which works well for private investors, as they are able to invest in sectors that will provide good returns(Suranovic, 2008). e) The floating exchange rate regime also indicates the relative scarcity of domestic currency in a given economy and this means that currency over-valuation is expressly eliminated. This leaves private investors with lots of confidence in dealing with the governments of such economies (Fairlamb & Rossant, 2003). PART 2 1. Eurozone Membership Limiting Scope of European Union Governments The Eurozone is a region of monetary and fiscal integration within the expansive European Union that exhibits the characteristics of advanced political and economic integration. Such characteristics include but are not limited to using a common European currency and legal tender, integrating monetary and fiscal policies by members of the Eurozone and other cooperation in other financial and economic issues, including the European Central bank which is the issuing authority in the economic and monetary zone. The Eurozone was established in 1999 with 11 member states and currently comprises of 18 European member states. Membership of the Eurozone has greatly limited the scope of the 18 different European governments who are signatories to the Euro group when it comes to monetary, fiscal, and economic and other financial matters (Friedrich & Huefner, 2004). In the past couple of years, many member states of the Eurozone have been having different financial and monetary issues, with members like Greece being on the verge of defaulting and total bankruptcy, to other like Spain and Cyprus suffering from very high rates of unemployment (Ramon et al. 2011). One of the ways in which Eurozone membership limited the scope of its member countries for sorting some of their financial issues is because all the monetary and fiscal policies of the zone are formulated and controlled by the European Central Bank. Matters dealing with the control of inflation are all left in the hands of this particular central bank. Even though the different members of the Eurozone that were facing financial problems had slightly varying problems, the European Central Bank would institute monetary and fiscal policies that would prevent other members of the zone from suffering rather than helping the struggling countries to overcome their financial difficulties.As such, the very existence of the European Central Bank has acted as a great hindrance to some of the Eurozone members that were struggling with financial problems such as Greece, Cyprus, Spain and Italy (Castle, 2011). Secondly, the Eurozone provides very heavy oversight over its members, especially when it comes to issues dealing with budgetary policies and taxation and the mechanisms of enforcing the zone’s economic, monetary and fiscal policies. This has been seen as an infringement to the sovereignty of the Eurozone member states, and such oversight also played a role in greatly diminishing the oversight of the different Eurozone governments that have been faced with different economic and financial problems in recent years. Thirdly, one of the recent requirements by the Eurozone is that all member states subject their national budgets to peer review by other members of the zone, six months prior to them being presented in their respective national assembly’s/parliaments (Ewing & Erlanger, 2012). Though one can argue that such a move fosters economic accountability within the Eurozone, it can conversely be argued that such moves limits the scope of governments who may be running deficits in order to correct certain domestic financial and economic problems such as rising unemployment, debt ridden sectors of their economies etc. In this vein, use of peer reviewed national budgets increases the stranglehold that the Eurozone has on its member states, and this greatly limits the scope of these very governments in tackling some of the financial and economic problems facing them (Wearden & Fletcher, 2012). 2. Responses if The European Countries Still had their National Currencies There are different responses that some Eurozone countries would have done if they still had their national currencies. Greece for instance, with its massive debt crisis, would have chosen to default, sparing it the tough austerity measures imposed on the country by the Eurozone. Having its own currency, Greece may have also devalued its currency to the debt crisis and rising hyperinflation (Piris, 2010).If Spain still had its previous national currency, the country could have maintained lower forex reserves to shore up and defend their domestic currency, thereby enabling them to utilize the remaining forex reserves in creating more employment opportunities for the millions of people suffering from unemployment (Rosenstreich, 2005). All these would have only happened had these two Eurozone member countries for instance still be having their national currencies, and as such control over most of their monetary, fiscal and financial policies. To conclude, this report shows that excessive control and oversight from the Eurozone and its biggest organ, the European Central Bankdetrimentally affected the recovery of some of the Eurozone countries that were faced with financial and economic crises in the past couple of years such as Greece, Spain, Italy and Cyprus, achieved through greatly limiting the scope of what the governments in these countries could do to help themselves out and fix their financial and economic problems (Craig &de Búrca, 2007). Recommendations This report recommends that the Eurozone and Eurogroup do away with the policies and restrictions that limit the scope of member governments when it comes to financial crises and problems facing individual economies. References List Bomberg, E, Peterson, J and Corbett, R. 2012. The European Union: How does it work?3rd Ed. Oxford: Oxford University Press. Calvo, G. and Reinhart, C. 2002. "Fear of floating". Quarterly Journal of Economics, vol.117no.2: p. 379–408. 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Forex revolution: An insider's guide to the real world of foreign Exchange trading. Upper Saddle River, NJ: Financial Times–Prentice Hall. Saccomanni, F,2008. Managing international financial instability: National Tamers versus Global Tigers. Cheltenham, UK: Edward Elgar Publishing Limited.* Smith, C,2007. International Trade and Globalization. 3rd Ed. Stocksfield: Anforme. Suranovic, S,2008. International Finance Theory and Policy. Palgrave Macmillan. Uzan, M,2005. The Future of the International Monetary System. Northampton, MA: Edward Elgar Publishing Limited. Wearden, G and Fletcher, N. 2012. "Eurozone crisis live: ECB to launch massive cash injection".The Guardian. Available Online at: http://www.theguardian.com/business/2012/feb/29/eurozone-debt-crisis-ecb-loans-ltro#block-3[Accessed on 9th May 2014] Read More