Question

a. One of the arguments for the creation of the euro was that it would lead to an increase in international trade, within the eurozone. Explain why this may be the case, specifically regarding exchange rate considerations.

b. Why would a country choose to have a fixed exchange rate, and to maintain an undervalued currency? What are the disadvantages to this policy? What are the benefits and drawbacks to an overvalued currency?

Answer 1

a. A single currency within the eurozone will mean that trade flow will be much easier between nations. Also the relative devaluation or overvaluation of currencies will not matter in such a situation.So in case there are multiple currencies within the eurozone then trade will be restricted in case one curency is highly valued and so purchasing that country's commodities seems very expensive for foreigners. Now with the presence of a single currency, trade will be smoother and freer and would easily allow the flow of trade across countries and hence a single currency is beneficial. Purchasing power parity is maintained in such a situation and so fluctuations across currencies is not an issue.

b. The maintaining of a undervalued currency will mean that goods in that country will seem very attractive price wise to foreigners. So lets say the US undervalues its currency then more dollars will be available to a unit of Australian dollars say. Thus Australians will find it much easier to purchase US goods. This benefits the US in that the US balance of trade condition will improve. Maintaining a fixed exchange rate will mean that the exchange rate will not fluctuate that much to foreign buying and selling and so the fluctuations in the balance of trade will not be that much. The disadvantages of a undervalued exchange rate would be that the economic fundamentals would be weak given the weak nature of the US currency. A fixed exchange rate would also mean that the exchange rate would not change with the changing economic climate. This will be an issue.An overvalued currency will mean that the currency is strong and so fewer dollars will be available to a unit of Japanese yen say. This will mean that the balance of trade in the US will worsen but it is a sign of a strong economy with robust economic fundamentals.