Question

The value and state of a currency have implications for several aspects of an economy. For several decades the Jamaican dollar has been floating relative to the US dollar, but places like Barbados and the regional bloc of Eastern Caribbean states have had fixed rates relative to the US dollar. Discuss these two methods with emphasis on the following;

a) the advantages of each.

b) the implications of each of these systems on export and import (balance of payments), inflation, unemployment, foreign exchange reserves and volatility.

Answer 1

a) The advantages of having a floating exchnage rate like that of Jamican dollar relative to the US dollar are-

• no requirement for external management systems
• the economy's balance of payments automatically adjusts itself
• banks do not have to intervene frequently
• no capital restrictions
• enhances market efficiencies

The advantages of having a fixed exchange rate are -

• encourages more trade as it provides more certainity
• intervention from the government helps in maintaining the interest rates and money supply in the economy and hence the rate of inflation
• avoids the fluctuations of the value of currency and hence volatiliy
• encourages more investment
• prevents the currency from devaluation

b) The implications of floating exchange rate on the following-

• Balance of payments - The BOP in floating exchange rate does not have to be externally maintained, it automatically adjusts itself. In the floating exchange rate system, the demand for currency automatically adjusts itself to the supply of the currency and hence, the deficit BOP also adjusts itself to zero level eventually.
• Inflation - The inflation would be difficult to control as the domestic currency automatically changes relative to other country's currency and hence the inccrease in money supply will increase inflation.
  Since there is no immediate government intervention, the inflation rate will persist longer in the economy before the GDP of the country adjusts itself.
• Unemployment - There will be high uncertainity of employment since the rate of exchange is flexible. There is an indirect relation between the exchange rate and the level of unemployment. When the country's exchange rate depreciates, the value of the country's currency falls and thus the domestic products become cheaper and increases competition. This increase in competition will in turn decrease rate of unemployment in the domestic economy.
• Foreign exchange reserves - There be high fluctuations of forex reserves in this case.
• Volatility- Prices in the floating exchange rate is highly volatile in nature since the value of currency fluctuates due to a change in exchange rates.

The implications of fixed exchange rate -

• BOP - Under fixed exchange rate, the balance of payments do not automatically adjusts itself unless the governmnet intervenes. As a result, when there is a trade deficit, the BOP will also be in deficit as well.
• Inflation - The rate of inflation is kept at moderate level under the fixed exchange rate system because of the intervention of the government.
• Unemployment - The unemployment rate under fixed exchange rate does not change since the exchange rate is also not flexible. The monetary policy becomes ineffective under the fixed exchange rate policy.
• Foreign exchnage reserves - The forex reserves will be less prone to fluctuations since the exchange rate is fixed.
• Volatility - There is no volatility under fixed exchange rate as the rate of exchange is constant.