advantages and disadvantages of fixed exchange rates

Question 1

advantages

Answer 1

-avoid fluctuations in currency which could make exports uncompetitive or imports more expensive

-stability encourages investment, some Japanese firms said UK’s reluctance to join euro and provide stable er less desirable place to invest, fixed ER= encourages firms to invest FDI

keeps inflation low, if currency devalues ( WPIDEC) - inflation, AD increases, cost push inflation, firms less incentive cut costs, fixed ER firms have incentive keep cutting costs remain competitive

current account- rapid appreciation badly effect firms that exports worsening CA

Question 2

drawbacks

Answer 2

• conflicts other objectives, if currency begins to fall would need to increase IR- hot money, reduce AD, lower eco growth, recession and low unemployment e.g. in 1992UK currency falling below ER floor, increased IR to 15%, reassign 1991/2

-less flexibility, difficult to reasond to temporary shocks e.g. rise in price oil, country oil importer- deterioration CA, in fixed ER no ability devalue/ reduce CA deficit

if overvalued- CA deficit

-if join at wrong rate , rater too high SPICED- exports uncompetitive , too low - inflation e.g. 1990 UK joined ERM rate too high- recession and high interest rates 1992