Question

Naked Economics: Wheelan

Wheelan discusses a variety of different mechanisms that countries can choose to determine nominal exchange rates. Two of them are A) fixed (pegged) exchange rates (including extreme versions like using someone else’s currency (dollarization) and currency boards), B) floating exchange rates. What are the advantages and disadvantages of these two approaches?

Answer 1

A. Advantages of Pegged Currency are -

1. Stable Basis for Economy: Currency pegs provide an extremely stable basis for financial planning to the governments. Governments have to buy essential commodities such as oil and food grains from the international market. Here, the government has to pay its expenses in a foreign currency. Usually this foreign currency is the United States dollar since it is the reserve currency of the world. If the rates are constantly fluctuating, the government cannot anticipate how much of its own currency will it require so that it can convert it to foreign currency and meet the demand. On the other hand, currency pegs fix the rate and provide a stable basis for governments to plan their revenues and expenditures in local currencies without any concerns about the volatile rates.
2. Credible And Disciplined Monetary Policy: Currency pegs makes the monetary policy disciplined as the government now to maintain peg, cannot print more money. It has to maintain the situation in foreign exchange market, due to which the inflation remain stable in the domestic economy.
3. Reduced Volatility: Apart from the governments, the local businesses also face advantages as a result of currency pegs. The local businesses can predict how their goods will be priced in the international market. Once they are aware of the exact pricing, they can also predict the quantities that will be demanded at that price. As such, they do not face any volatility and can insulate themselves from foreign exchange losses.

Disadvantages of pegging the currency are –

1. Increased Foreign Influence: Countries which adopt a currency peg face increased foreign influence in their domestic affairs. This is because their monetary policy is determined by another nation. A lot of times, this leads to a conflict of situation and capturing of domestic economic power in someone else hands.
2. Difficulty in Automatic Adjustment: A floating currency system leads to automatic adjustment of deficits. For instance, if one country imports too much, they will have to pay out a lot. This will lead to a increase in currency supply in forex market to buy dollars to pay other countries causing inflation in domestic market. Higher inflation means depreciation in exchange rate of domestic currency thus make their domestic exports competitive.
3. Speculative Attacks: Speculative attacks on a currency can happen if it deviates too much from its macro fundamentals. Currency pegs may create a huge difference in the fundamental value of a currency and its market value. This is because the Central Bank tries to artificially manipulate the value. And when the speculators think that the peg will not be able to survive they short the currency in Forex market, which results in large depletion of Foreign Exchange reserves of the Central Bank, and even force it to leave the peg.

B. Advantages of Floating Currency are –

1. Market Determined Rates: Freely floating exchange rate means that the market will determine the rate at which one currency can be exchanged for another. The market will set these rates on a real time basis as and when new information flows in. This reduces the need for an elaborate mechanism to ensure that the exchange rates remain within a particular range. In case of a floating exchange rate, the central bank does not have to take so many efforts. Instead, it can just passively manage the currency by setting important rates and interfering in the market only when it becomes necessary.
2. Less Probability of Speculative Attacks: As currency adjust itself with changing fundamentals a freely floating currency faces adjustment on a minute to minute basis. There are some days that the currency faces rapid appreciation whereas others when it faces rapid decline. However, for most of the days, the currency remains stable.
3. Low Requirement of FX Reserves: A freely floating exchange system does not require the central bank to hold massive reserves. This is because the Central Bank does not have to intervene to maintain the value of the currency. Central Bank operations are a very rare event for countries that have a floating rate system. This helps them to maintain reserves only for trading with other countries rather than using the reserves for intervening in theFX market.

Disadvantages of Floating Currency are –

1. Uncertainty: A freely floating currency rate implies a lot of volatility. The value of currencies change on a real time basis. Also, since Forex market is not regulated, currency values could skyrocket or hit rock bottom in a matter of minutes. In the short run, traders find it difficult to engage in foreign trade since they are not aware of the exact prices that their goods will fetch them. Movements in the currency market can cause a significant dent in the profits of the Businesses.
2. Allocation of Resources: At a macro level, the economy faces a problem while allocating resources. This is because as exchange rates change so does the benefit that can be derived from resources. For instance, a rising exchange rate makes imports a better option whereas a falling rate makes exports easier. Hence, if exchange rate keeps of fluctuating, the country cannot really create a long term strategy and stick to it. The allocation of resources is optimized in the short run. However, in the long run, this allocation seems to be ad-hoc since it does not follow any given plan.
3. Lack of Discipline: Lastly, freely floating exchange rates only make sense if the country has sufficient internal control mechanisms in place. Hence, if there is likelihood that the monetary policy may be misused for personal gains by a group of influential people, then it is better to peg the currency to another more developed currency. In this way, fiscal discipline is imposed on the economy. Freely floating currencies provide independence. However, the independence can only be utilized if the economy is disciplined enough.

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