Fixed/pegged Exchange rates

Question 1

1) What are the advantages of a fixed or Pegged exchange rate?

Answer 1

1. Avoid currency fluctuations. If the value of currencies fluctuates, significantly this can cause problems for firms engaged in trade.

For example, if a firm is exporting, a rapid appreciation in Sterling would make its exports uncompetitive and therefore may go out of business.

If a firm relies on imported raw materials, a devaluation would increase the costs of imports and would reduce profitability

Question 2

2) What are the advantages of a fixed or Pegged exchange rate?

Answer 2

2. Stability encourages investment.

The uncertainty of exchange rate fluctuations can reduce the incentive for firms to invest in export capacity. Some Japanese firms have said that the UK’s reluctance to join the Euro and provide a stable exchange rate makes the UK a less desirable place to invest. A fixed exchange rate provides greater certainty and encourages firms to invest.

Question 3

3) What are the advantages of a fixed or Pegged exchange rate?

Answer 3

3. Keep inflation low.

Governments who allow their exchange rate to devalue may cause inflationary pressures to occur. Devaluation of a currency can cause inflation because AD increases, import prices increase and firms have less incentive to cut costs.

A fixed exchange rate, by contrast, means firms have an incentive to keep cutting costs to remain competitive.

Question 4

4) What are the advantages of a fixed or Pegged exchange rate?

Answer 4

4. Current account.

A rapid appreciation in the exchange rate will badly effect manufacturing firms who export; this may also cause a worsening of the current account.

Question 5

1) What are the disadvantages of a fixed or pegged exchange rate?

Answer 5

1. Conflict with other macroeconomic objectives.

To maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives.

If a currency is under pressure and falling – 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 aggregate demand (AD) and lower economic growth, If the economy is growing slowly this may cause a recession and rising unemployment.

Question 6

2) What are the disadvantages of a fixed or pegged exchange rate?

Answer 6

2. Less flexibility.

In a fixed exchange rate, it is difficult to respond to temporary shocks. For example, if the price of oil increases, a country which is a net oil importer will see a deterioration in the current account balance of payments. But in a fixed exchange rate system, there is no ability to devalue and reduce current account deficit