4) Fixed v Floating Exchange Rates - MMT

Question 1

who are fixed rates determined by?

Answer 1

the central bank of a country

Question 2

how does the central bank actively manage a fixed currency?

Answer 2

normally this involves choosing an x-rate of their currency versus a larger currency and actively managing the currency in order to stay close to this rate

Question 3

floating x-rates are not managed, instead they … all the time

Answer 3

fluctuate

Question 4

how are floating x-rates determined?

Answer 4

by changing demand and supply of the currency as it is traded on the FOREX

Question 5

how do fixes rates provide economic stability vs floating x-rates?

Answer 5

• floating x-rates can be highly volatile and are often a source of great uncertainty for economic agents
• uncertainty undermines confidence

-with fixed rates, this uncertainty is reduced

• therefore, economic agents are in a better position to make plans for the future, encouraging investment and economic growth

Question 6

how do fixed rates give businesses a much greater sense of their true international competitiveness?

Answer 6

• sometimes, changes in x-rates can mask inefficiencies allowing higher costs to become endemic

Question 7

what do many countries that operate fixed rates prefer?

Answer 7

internal devaluation to actual devaluation

Question 8

what does internal devaluation mean?

Answer 8

using efficiency savings such as national restraint (wage), increasing the efficiency and productivity of firms in the country

Internal devaluation is an economic and social policy option whose aim is to restore the international competitiveness of some country mainly by reducing its labour costs – either wages or the indirect costs of employers.

Question 9

are floating or fixed rates better at tackling inflation?

Answer 9

generally, fixed rates are better at countering domestic inflation (eg caused by wage increases) but floating rates may be better at controlling imported inflation (eg from oil price increases)

Question 10

how do fixes rates create a lower opportunity cost for businesses?

Answer 10

owners and directors of many small to medium sized businesses, engaged in international trade, spend a great deal of their time second-guessing and speculating on x-rate movements. Often this distracts from their focus on effectively managing the core work of their business. Again, fixed rates reduce this level of distraction whilst also preventing costly mistakes

Question 11

how do countries with floating rates have the flexibility of monetary policy?

Answer 11

• when a central bank looks to implement and maintain a fixed x-rates regime, doing so becomes almost the whole focus of their monetary policy
• this reduces the freedom they would otherwise have to use interest changes to manage the economy
• with floating rates, the central bank can reduce interest rates in order to boost growth, increase interest rates to control inflation
• this is far more difficult in a fixed rate regime as changes in interest rates destabilise the x-rate

Question 12

how do floating rates automatically correct shocks/trade deficits?

Answer 12

• X-rates are a price (price of foreign currency)
• like any price, changes in demand and supply act as an invisible hand, continuously restoring equilibrium
• so if the country faces a large trade deficit (e.g. M>X), it’s inevitable that the supply of its currency (from M) exceeds demand (from x)
• this will lead to a fall in the x-rate
• a weaker x-rate (WPIDEC) will mark exports cheaper, increasing demand for them and imports more expensive, reducing demand for M
• in this way, x-rate changes automatically correct excessive trade imbalances
• if the country suffers from a deep economic shock it’s x-rate might collapse due to capital flight
• overtime however a lower x-rate may help to boost economic growth (higher x, lower m) restoring some confidence and helping the economy to recover from the shock
• eg fallout from the Brexit referendum 2016

Question 13

how can floating rates promote economic growth?

Answer 13

• with floating rates, the central bank does not need to keep purchasing and selling foreign currency
• this means that they can stock far fewer reserves of foreign currency
• hence, the reserves can be utilised from promoting economic growth by investing in more profitable assets

Question 14

what 3 things can fixed rates provide?

Answer 14

1) economic stability
2) give businesses a much greater sense of their true international competitiveness
3) lower opportunity cost for businesses

Question 15

what 3 things can floating rates provide?

Answer 15

1) flexibility of monetary policy
2) automatic correction of shocks/trade deficits
3) the central bank does not need to keep purchasing and selling foreign currency

Question 16

what matters choosing between having a fixed currency and floating currency depend on? 3 things

Answer 16

1) the size and type of economy
2) the effectiveness of your central bank/monetary policy
3) circumstances (cesteris paribus)

Question 17

who are more likely to use floating x-rates?

Answer 17

major developed economies, such as the USA, UK, Eurozone etc, they want to be independent of other countries, not reliant on them

Question 18

who are more likely to use fixed x-rates?

Answer 18

small countries, whose trade may be dominated by one partner (eg Denmark and the Eurozone) may prefer the stability of having a fixed-rate with that

Question 19

why do floating or fixed rates depend on the effectiveness of your central bank/monetary policy? (talk about major developed economies)

Answer 19

• major developed economies, such as USA, Eurozone etc, are likely to have strong, well-established and powerful central banks, operating effective monetary policies
• floating x-rates are far more appropriate for them

Question 20

why do floating or fixed rates depend on the effectiveness of your central bank/monetary policy? (talk about less stable economies)

Answer 20

• less stable (perhaps developing economies) have less secure institutions and their central banks may struggle with effective monetary policy
• fixed rates suit them as it narrows the range of their monetary policy to one job-keeping the x-rate stable

Question 21

why do floating or fixed rates depend on ceteris paribus?

Answer 21

many economies (e.g Poland) are big and strong enough to operate completely floating rates but are required to keep a fixed rate v the Euro. This is because they will, in time, be joining the Euro and a fixed rate is essential for them to be able to merge efficiently into the new currency