QUESTIONS AND APPLICATIONS 1. Exchange Rate Systems Compare and contrast the fix
ID: 2711411 • Letter: Q
Question
QUESTIONS AND APPLICATIONS 1. Exchange Rate Systems Compare and contrast the fixed, freely floating, and managed float exchange rate systems. What are some advantages and disadvantages of a freely floating exchange rate system versa; a fixed exchange rate system? 2. Intervention with Euros Assume that Belgium, one of the European countries that uses the euro as its currency, would prefer that its currency depreciate against the U.S. dollar. Can it apply central bank intervention to achieve this objective? Explain. 3. Direct Intervention How can a central bank use ilium intervention to change the value of a currency? Explain why a central bank may desire to smooth exchange rate movements or its currency. 4. Indirect Intervention How can a central bank use indirect intervention to change the value of a currency? 5. Intervention Effects Assume there is concern that the United State, may experience a recession. How should the Federal Reserve influence the dollar to prevent a recession? How ought U.S. exporters react to this policy (favorably or unfavorably? What about U.S. importing Firms? 6. Currency Effects on Economy What is the impact of a weak home currency on the home economy, other things being equal? What is the impact of a strong home currency on the home economy, other things being equal? 7. Feedback Effects Explain the potential feedback effects of a currency's changing value on inflation. 8. Indirect Intervention Why would the Fed's indirect intervention have a stronger impact on some currencies than others? Why would a central bank'sExplanation / Answer
1. FLOATING EXCHANGE RATE
Floating exchange rates have these main advantages:
No need for international management of exchange rates: Unlike fixed exchange rates based on a metallic standard, floating exchange rates don’t require an international manager such as the International Monetary Fund to look over current account imbalances. Under the floating system, if a country has large current account deficits, its currency depreciates.
No need for frequent central bank intervention: Central banks frequently must intervene in foreign exchange markets under the fixed exchange rate regime to protect the gold parity, but such is not the case under the floating regime. Here there’s no parity to uphold.
No need for elaborate capital flow restrictions: It is difficult to keep the parity intact in a fixed exchange rate regime while portfolio flows are moving in and out of the country. In a floating exchange rate regime, the macroeconomic fundamentals of countries affect the exchange rate in international markets, which, in turn, affect portfolio flows between countries. Therefore, floating exchange rate regimes enhance market efficiency.
Greater insulation from other countries’ economic problems: Under a fixed exchange rate regime, countries export their macroeconomic problems to other countries. Suppose that the inflation rate in the U.S. is rising relative to that of the Euro-zone.
Under a fixed exchange rate regime, this scenario leads to an increased U.S. demand for European goods, which then increases the Euro-zone’s price level. Under a floating exchange rate system, however, countries are more insulated from other countries’ macroeconomic problems. A rising U.S. inflation instead depreciates the dollar, curbing the U.S. demand for European goods.
Floating exchange rates also have disadvantages:
Higher volatility: Floating exchange rates are highly volatile. Additionally, macroeconomic fundamentals can’t explain especially short-run volatility in floating exchange rates.
Use of scarce resources to predict exchange rates: Higher volatility in exchange rates increases the exchange rate risk that financial market participants face. Therefore, they allocate substantial resources to predict the changes in the exchange rate, in an effort to manage their exposure to exchange rate risk.
Tendency to worsen existing problems: Floating exchange rates may aggravate existing problems in the economy. If the country is already experiencing economic problems such as higher inflation or unemployment, floating exchange rates may make the situation worse. FIXED EXCHANGE RATE
Advantages of Fixed Exchange Rates
1. Avoid Currency Fluctuations. If the value of currencies fluctuate significantly this can cause problems for firms engaged in trade.
4. Current Account Imbalances. Fixed exchange rates can lead to current account imbalances. For example, an overvalued exchange rate could cause a current account deficit. See: problems of overvalued exchange rate.
3. Keep inflation Low. Governments who allow their exchange rate to devalue may cause inflationary pressures to occur. This is because AD increases, import prices increase and firms have less incentive to cut costs.
4. A rapid appreciation in the exchange rate will badly effect manufacturing firms who export, this may also cause a worsening of the current account.
5. Joining a fixed exchange rate may cause inflationary expectations to be lower
Disadvantage of Fixed Exchange Rates
1. Conflict with other objectives. To maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives.
· If a currency is falling below its band the government will have to intervene. It can do this by buying sterling but this is only a short term measure.
· The most effective way to increase the value of a currency is to raise interest rates. This will increase hot money flows and also reduce inflationary pressures.
· However higher interest rates will cause lower AD and economic growth, if the economy is growing slowly this may cause a recession and rising unemployment
2. Less Flexibility. It is difficult to respond to temporary shocks. For example an oil importer may face a balance of payments deficit if oil price increases, but in a fixed exchange rate there is little chance to devalue.
3. Join at the Wrong Rate. It is difficult to know the right rate to join at. If the rate is too high, it will make exports uncompetitive. If it is too low, it could cause inflation. MANAGED FLOATING EXCHANGE RATE Under the managed floating regime, though exchange rate is determined by market forces of demand and supply, the central banks or the governments set some kind target exchange rate to protect their exports/import.
Fluctuations in the exchange rate can provide an automatic adjustment for countries with a large balance of payments deficit. If an economy has a large deficit, there is a net outflow of currency from the country. This puts downward pressure on the exchange rate and if a depreciation occurs, the relative price of exports in overseas markets falls while the relative price of imports in the home markets goes up. This leads to reduce the overall deficit in the balance of trade provided that the price elasticity of demand for exports and the price elasticity of demand for imports is sufficiently high. • Floating exchange rates gives the government / monetary authorities’ flexibility in determining interest rates. This is because interest rates do not have to be set to keep the value of the exchange rate within pre-determined bands. • Balance of Payments on current account disequilibrium can automatically be restored to equilibrium floating exchange rate regime and the scarcity or surplus of any currency is eliminated under floating exchange rate regime. Balance of payment adjustment is smoother and painless under floating exchange rate regime compared to fixed exchange rate system. • Autonomy of monetary authorities preserve under floating exchange rate system as there is no target exchange rate to maintain. The fundamental argument in favour floating exchange rate system is that it allows countries autonomy with respect to their use of monetary, fiscal and other policy instruments and at the sametime external equilibrium is ensured because of flexible exchange rate. • Market forces may fail to determine the appropriate exchange rate and hence floating exchange rate regime may not provide the desired results and may also lead to misallocation of resources. • It is impossible to have an exchange rate system without official intervention. Government may not intervene, however domestic monetary policy and fiscal policy would definitely influence the exchange rate. • A wildly fluctuating exchange rate at the mercy of national and international currency speculators. Volatile exchange rate introduces considerable uncertainty in export and import prices and consequently to economic development. At the sametime, abolition of exchange controls causes capital flight. Advantages of floating exchange rates
Arguments against floating exchange rates
• Market forces may fail to determine the appropriate exchange rate and hence floating exchange rate regime may not provide the desired results and may also lead to misallocation of resources. • It is impossible to have an exchange rate system without official intervention. Government may not intervene, however domestic monetary policy and fiscal policy would definitely influence the exchange rate. • A wildly fluctuating exchange rate at the mercy of national and international currency speculators. Volatile exchange rate introduces considerable uncertainty in export and import prices and consequently to economic development. At the sametime, abolition of exchange controls causes capital flight. 2.
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