Question

Assuming fixed exchange rates between two economies of Sweden and Norway (Euro). Productivity in Sweden is higher than in Norway, so the cost of production in Sweden is lower because of technology, how will this affect the fixed exchange rate and stability of the euro?

Answer 1

The policy of "Fixed Exchange Rate" system, introduced by the government or the central bank of a country, fixes the value of its currency against the value of another nation's currency. The fixed value of money makes the trade (exports & imports) more feasible and easy between the two.

In the above case Sweden and Norway are ejoying the benefits of fixed exchange rates while trading. While it is mentioned that productivity of Sweden is higher than that of Norway as it uses modern technologies which makes its production process more cost-effective and hence, yields more profits to its economy.

In the long-run as the situation persists, Sweden will avoid investing in the Norweigian firms and would prefer to produce the goods in its own country. Further, it will export the same in Norway making the domestic competitors face heavy losses. As the prices of goods produced in Sweden will be low in comparison to the similar goods produced in Norway.

Thus, Norway's GDP will decline due to lesser investments, productions, and demand of its products. There will be uncertainity in the economy, by generating unemployment, poverty, bankruptcy, and would also severely affect the value of its currency to decline. This will lead the government to intervene for stabilizing the falling value of its currency, thus, increasing the interests rates and leaving the exchange rate ties with Seden.

It will impose tariff duties on trade with Sweden, which will hence make the prices of imported goods from Sweden soar higher than that of domestic goods. The demand for Domestic goods will rise in Norway, thus, improving the growth rate of the economy and value of it currency too.

Subsequently, if the fixed exchange rate ties between Sweden and Norway will be dissolved by the Norweigian government, the value of Euro (the common currency used in Europe as a exchange rate policy) will also depreciate. As the trade percentage between the two countries will fall and so the value of euro.