Question

1. This question is on fixed vs. floating exchange rates.

1. Describe the major benefits and costs of fixing exchange rates. (2pts)

2. Explain how monetary policy coordination works in a fixed exchange rate system.  What is/are the major obstacle(s) to such coordination? (2 pts)

Answer 1

Benefits of exchange rate

Benefits of Fixed Exchange Rate

1. Helps to reduce inflation. The argument is that if you are in a fixed exchange rate, you need to keep inflation low, otherwise the currency will start to fall below the target level. In a floating exchange rate, countries with high inflation can merely devalue, therefore there is less anti-inflation discipline.

2. Helps reduce uncertainty and increase investment. Fixed exchange rates enable firms to plan ahead because they know future costs and prices of exports and imports. This should encourage investment because firms have a better plan about the future. For example, in a floating exchange rate, a rapid appreciation can make your exports uncompetitive and you could even go out of business because of fluctuations in the exchange rate.

3. Prevents destabilising movements in the exchange rate. In a floating exchange rate, the value of the currency can frequently change. A rapid depreciation, would increase the cost of imports and raw materials. A rapid appreciation could make an export firm uncompetitive.

Cost of exchange rate

1. Wrong Value. If you join an exchange rate at the wrong value, it can cause certain problems. If the value of the exchange rate is too high, then exports will become uncompetitive; this can lead to lower demand and lower growth.
2. Current account imbalance. If an economy joins an exchange rate at the wrong level, it can cause current account imbalance. For example, in 2007, economies like Spain and Greece were
3. Overvalued Difficult to keep exchange rate at correct level. If markets think exchange rates are overvalued, the government will have to intervene to keep the value high. For example, they may need to sell foreign exchange reserves and buy own currency. They may also need to increase interest rates to attract ‘hot money flows’
4. THE following are the impact of fixed rate on monetary policy   A fixed exchange rate system can also be used to control the behavior of a currency, such as by limiting rates of inflation. However, in doing so, the pegged currency is then controlled by its reference value. As such, when the reference value rises or falls, it then follows that the value(s) of any currencies pegged to it will also rise and fall in relation to other currencies and commodities with which the pegged currency can be traded. In other words, a pegged currency is dependent on its reference value to dictate how its current worth is defined at any given time. In addition, according to the Mundell–Fleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy to achieve macroeconomic stability.