Question

Do you believe countries are able to earn higher revenues (profits) at a global level if they are using a floating exchange rate system?

When did the U.S. move away from a fixed exchange rate system to a floating rate system?

If our country still adopted a fixed exchange rate system, do you believe the U.S. would have incur less national debt as a result?

Please provide real-life examples.

Answer 1

When we hear the words “exchange rate” we know that it refers to the price of one country’s currency in terms of another country’s currency. Exchange rate can be of two types- fixed and floating (flexible).

When a country’s exchange rate is floating, the price of the domestic currency in terms of the foreign currency is determined by the interaction of freely moving market forces of demand and supply in the foreign exchange market. As exchange rate increases, we say that the domestic currency depreciates (i.e. the value of domestic currency falls and the foreign currency becomes more expensive.) When the exchange rate is fixed, the government pegs or fixes the exchange rate legally and doesn’t rely on the foreign exchange market. Usually the government likes to keep a devalued or purposely a low value of domestic currency. This makes the domestic currency cheap in foreign markets and helps to boost exports and thus, earnings. Whenever the value of domestic currency reduces in relation to the foreign currency under a floating exchange rate system, it is known as depreciation. Similarly when the dometic currency's value is forcefully lowered following a fixed exchange rate system, then it is known as devaulation.

Higher revenues or profits would require the country’s earnings (through exports) to be greater than the country’s expenditure (on imports). Under a floating regime depending on the demand and supply of Dollars, there is no guarantee that the exchange rate will be high enough to push up domestic exports. For example, India’s current dollar exchange rate is $1= ₹ 64.94. This makes Indian goods relatively cheap in USA and increases its exports to USA. However, had India followed a fixed exchange rate regime and forcefully pegged the value of India’s currency further down, (e.g. at $1= ₹ 80), this would make the Dollar costlier by ₹ 15 more in India. Imports would be driven down as foreign goods would become very expensive. Simultaneously, Indian goods would become very cheap in USA and USA’s import (which is India’s export) would shoot up. Compared to the scenario under floating regime, the fixed exchange rate shows a higher rise in the India’s revenue. Also as imports fall and spending reduces, the difference between earning and spending widens and India’s global profit levels are higher compared to those under a floating exchange rate regime. In real life, this is exactly what China does. It follows a fixed exchange rate system and devalues Chinese currency to an extent which generates humongous profits and growth rates which would otherwise never have been possible under a floating exchange rate system.

Way before the floating exchange rate regime, USA had followed Silver, Gold and Fiat standard. Near the end of World War II, Bretton Woods was born which laid out plans for the IMF, the World Bank and the International Trade Organization. While Bretton Woods was in action, fixed currencies became the norm and USA’s dollar was pegged to gold. However, with depleting gold reserves, President Nixon who held office in USA at that time forcefully devalued US currency and declared that US would not convert its currency into gold any further. This came at the time of collapse of the Bretton Woods system. In 1973, USA converted to a floating exchange rate system, following a period known as the “Nixon shock”.

Floating exchange rate which fluctuates with the market forces brings with it a lot of volatility. However, that volatility affects developing economies on a larger scale than developed economies. When it comes to USA and its national debt, the story is quite interesting. Taking a real life example of China, which follows a fixed exchange rate regime, the country is believed to be one of the most significant contributors to USA’s national debt. The whole idea of China’s fixed exchange rate is to keep its currency so low that Chinese goods are very cheap and its export increases. Simultaneously, USA’s good are so expensive in China that its import reduces. This is exactly what has happened which led to an enormous trade deficit in the USA. Additionally, China buys US Treasury securities to deliberate keep its currency’s value low, which are then lent to the USA as and when demanded. Currently, China contributes more than $1 Trillion of US’s national debt. After China, Japan comes second. Thus, off late, in case of noticeable rise in India’s Forex reserves and an increasing trade deficit, close watch is kept on RBI’s operations by the US government to prevent India from doing to US’s debt what China is doing. China’s tremendously devalued currency makes US companies lose competitive advantage and stop production because they cannot compete with China’s ridiculously low costs of production. This further aggravates the deficits as domestic earnings are way below domestic expenditure on imported Chinese products. Thus, if our country adopted a fixed exchange rate system, USA would not have incurred a less national debt.