6.5 - The Floating Exchange Rate Flashcards
1) What is one advantage of floating exchange rates in terms of currency reserves?
One advantage of floating exchange rates is that there is a reduced need for currency reserves. This means that the central bank, such as the Bank of England, doesn’t have to hold large scale reserves of foreign currency for intervention in the markets. Holding such reserves is costly and carries a large opportunity cost. By saving this expense, the government can allocate those resources to more productive areas of the economy, leading to sustained and sustainable economic growth in the long term.
2) How does floating exchange rates provide freedom for domestic monetary policy?
Floating exchange rates provide freedom, also known as autonomy, for domestic monetary policy. The absence of an exchange rate target allows the central bank to set interest rates according to domestic macroeconomic objectives, such as stabilizing growth or controlling inflation. This flexibility is not possible under a fixed exchange rate regime, where any changes to interest rates would affect the ability to maintain the fixed rate. With floating exchange rates, the central bank can adjust interest rates independently to address domestic economic conditions.
3) How can a floating exchange rate act as a useful tool of macroeconomic adjustment?
A floating exchange rate can act as a useful tool of macroeconomic adjustment in various ways. For example, depreciation of the currency can stimulate growth by boosting net export demand. Countries within the Euro Zone, for instance, may hope for a more competitive, weaker Euro to inject demand into their slow-growing economies. On the other hand, appreciation of the currency can help control inflation and keep it towards the target. The flexibility of the floating exchange rate allows for adjustments that align with specific macroeconomic goals and conditions.
4) What role do floating exchange rates play in correcting trade imbalances?
Floating exchange rates offer a partial automatic correction mechanism for trade imbalances. When a country experiences a large trade deficit, the exchange rate comes under downward pressure. This depreciation makes imports more expensive and boosts export revenues, thereby reducing demand for imports and self-rectifying the trade deficit. Conversely, if a country has a large trade surplus, upward pressure on the exchange rate occurs, reducing export revenues and increasing import expenditure, which helps bring the surplus back to balance. Floating exchange rates contribute to the adjustment process in the face of trade imbalances.
5) How does the absence of an explicit exchange rate target reduce the risk of currency speculation in floating exchange rate systems?
The absence of an explicit exchange rate target in floating exchange rate systems reduces the risk of currency speculation. Speculators often target fixed exchange rates that they believe are fundamentally over or undervalued. However, under floating exchange rate systems, in theory, the exchange rate reflects purchasing power parity (PPP). This alignment between exchange rates and PPP reduces the likelihood of speculative attacks, as there is less opportunity for speculators to profit from deviations. Therefore, floating exchange rates are less prone to speculative attacks that could trigger economic crises compared to fixed exchange rate regimes. Floating exchange rates provide more stability in this regard.
How can volatile floating exchange rates impact businesses and the economy?
Volatile floating exchange rates can create uncertainty for businesses, making it difficult for them to accurately predict their future costs and revenues. This uncertainty makes it challenging to assess the level of risk and return on investments, leading to reduced levels of investment. Additionally, exporters and importers face difficulties in interpreting short-term versus long-term changes in the exchange rate, further adding to the uncertainty and reducing the volume of trade. Foreign firms also become wary of volatile exchange rates, which acts as a deterrent to investing abroad, resulting in less foreign direct investment (FDI) due to uncertainty over costs and potential revenues from export sales. Ultimately, these impacts of uncertainty and reduced investment and trade lead to reduced actual and potential growth for the economy.
2) What are the limitations of floating exchange rates in terms of trade imbalances and purchasing power parity (PPP)?
Floating exchange rates do not necessarily self-adjust to eliminate trade imbalances, nor do they always reflect purchasing power parity (PPP). This is because there are other dominant factors, apart from trade, that can influence movements in the exchange rate, thereby preventing PPP from always being reflected and stopping downward pressure on the exchange rate due to a trade deficit. As a consequence, any benefits that may exist in terms of trade imbalances and PPP adjustment under floating exchange rates are minimal, if they exist at all in reality.
3) How can a floating exchange rate potentially worsen inflation in a country?
A floating exchange rate may contribute to worsened inflation in a country. If a country experiences high relative inflation, it makes its exports less competitive and imports relatively more expensive. As a result, the exchange rate falls due to an increase in the supply of the currency compared to the demand for it. However, this can lead to demand-pull inflation as the increase in net exports (exports - imports) pushes up aggregate demand. Additionally, the import prices of components and raw materials for businesses increase, leading to cost-push inflation. Consequently, the overall inflation rate rises above the target level, creating challenges for managing inflationary pressures in the economy.
1) How does a fixed exchange rate regime promote trade and investment?
A fixed exchange rate regime promotes trade and investment by reducing exchange rate uncertainty. Businesses find it easier to plan for the future as they can make more accurate predictions about their likely costs and revenues. This clarity in assessing the level of risk and return on investment increases investment levels. Exporters and importers also gain confidence in the long-term value of the exchange rate under a fixed regime, leading to increased volume of trade. Moreover, stable exchange rates act as an incentive for foreign firms to invest abroad (FDI) as they have more certainty over their costs and potential revenues from export sales. Consequently, all three impacts - reduced uncertainty, increased investment, and higher trade volume - contribute to increased actual and potential growth for the economy.
2) What flexibility is permitted in a fixed exchange rate regime?
A fixed exchange rate regime allows for some flexibility through occasional devaluations or revaluations of the currency. If the economic case becomes compelling and exchange rates are set damagingly high or low, countries can negotiate agreements with other countries for parity adjustments. However, countries with fixed exchange rates are often reluctant to make such adjustments, as these decisions can be seen as politically damaging and may create uncertainty or confusion, which goes against the main idea of maintaining a fixed exchange rate regime in the first place.
3) How does a fixed exchange rate regime reduce the costs of trade?
A fixed exchange rate regime reduces the costs of trade, particularly in terms of currency hedging. Businesses often hedge against currency volatility by buying the needed currency in the forward currency markets, which can be riskier and more expensive than purchasing in the spot markets. With a fixed exchange rate, businesses can spend less on currency hedging because they know that the currency will maintain its value in the foreign exchange markets. This reduction in currency hedging costs enables businesses to allocate their money more productively, such as for investment purposes. Consequently, a fixed exchange rate regime lowers the costs associated with trade, allowing businesses to utilize their resources more efficiently.
4) How does a fixed exchange rate regime impose disciplines on domestic producers?
A fixed exchange rate regime imposes disciplines on domestic producers, particularly exporters, as they are forced to enhance the competitiveness of their goods and services to maintain strong export sales and revenue. Under a fixed regime, they cannot rely on benefiting from weaker exchange rates. To remain competitive, exporters may implement various measures such as training programs to boost staff productivity, capital investments, exploiting economies of scale, and negotiating better deals with raw material suppliers. These actions not only benefit individual firms but can also have positive spill-over effects on the overall economy. If such activities spread across the economy, both short-term and long-term growth can be promoted. Persistent net export increases and improvements in competitiveness contribute to an increase in aggregate demand (AD) and the long-run aggregate supply (LAS). This, in turn, leads to overall growth in the economy, benefiting both individual firms and the broader macroeconomic performance.
