Evaluating Free-floating vs Fixed Exchange Rate Systems

Question 1

Comparing & Contrasting Fixed & Floating Exchange Rate Systems

Answer 1

1. Degree of certainty for stakeholders
2. Role of foreign currency reserves
3. Correction of current account imbalances
4. Effects on inflation
5. Flexibility offered to policy-makers
6. Effects on speculation

Question 2

1. Degree of certainty for stakeholders

Answer 2

Advantage fixed: b/c greater predictability

There will be no change in import costs / export revenues b/c no change in foreign exchange

Less uncertainty = more govn’t spending, more consumption & more foreign & domestic investment

B/c governments, firms, consumers can plan for future

Fixed rate makes handling foreign debt more manageable
- B/c capital & interest payments are predictable

Fixed exchange rates boosts international trade & can improve allocation of resources

Disadvantage floating:

Unpredictable for firms, consumers, govn’t, & foreign investors

Less international trade, investment, & consumption, growth

Question 3

2. Role of foreign currency reserves

Answer 3

Advantage: floating

Govn’ts can use their foreign reserves for importing capital goods instead of manipulating their forex rate

Disadvantage fixed: Country needs large foreign reserves to strengthen currency & discourage speculators

Question 4

3. Correction of current account imbalances

Answer 4

Advantage: floating

Current account deficit/surplus is self-correcting

Currency depreciates due to a trade deficit
- Makes imports more expensive & exports cheaper
- Deficit shrinks currency strengthens as a result
- Current account deficit shrinks!

Disadvantage fixed:

Extreme measures needed to correct persistent current account deficit (b/c depreciating effect)

No easy adjustment to external shocks (i.e. higher oil prices)
(need gov intervention)

All negatives of protectionism & debt
- Inefficiency, misallocation, retaliation, unemployment, recession, slower future growth, opp. cost

Question 5

4. Effects on inflation

Answer 5

Advantage: fixed

Inflation would lead to greater current account deficit b/c of cheaper imports & more expensive exports
- However, deficit would be corrected over time due to depreciation
- BUT, depreciation leads to more inflation!!!

Low inflation becomes govn’t priority b/c high inflation would cause currency to depreciate

So, govn’ts need to maintain fiscal policy discipline

To remain competitive w/imports, domestic firms are pressured to be efficient—keeping costs & prices down

Question 6

5. Flexibility offered to policy-makers

Answer 6

Advantage floating:

Govn’t has more economic policy freedom & doesn’t have to worry about current account deficit/surplus

Doesn’t have to use contractionary fiscal policy to weaken its currency & decrease imports

However, govn’ts w/free floating are more likely to use politically popular expansionary monetary policies for growth
- As a result, currency depreciates🡪 creating inflation
- Slower growth due to cost-push inflation

Disadvantage fixed:
B/c govn’t MUST maintain exchange rate at fixed level, it often requires actions which have negative domestic impact

Country is experiencing recession w/high unemployment?
Can’t use monetary policy to lower interest rates b/c causes currency would depreciate

Question 7

6. Speculation

Answer 7

Advantage fixed:

b/c no forex Δ occurs

Speculation causes exchange fluctuation in floating system

However, if govn’t w/fixed regime is running low on reserves, can lead to risk of speculation & may add pressure w/belief a devaluation is imminent