Question

1). a. Describe two different currency systems that have been introduced to improve the credibility of pegged exchange rate systems.

b. Do you think the Euro will survive?

*Please type and answer in detail*

Answer 1

1. a)The exchange-rate system is an important topic in international economic policy. Policymakers and journalists often seem to treat the choice of exchange rate system as one of the most important economic policy choices that a national government makes, on a par with free international trade. Meanwhile, the past two decades have witnessed major changes in the focus of academic discussions on alternative exchange-rate systems, and while the newer focus has yet to make its way to policy circles, it has brought economists closer to a consensus on appropriate exchange-rate policy in the face of genuine scientific uncertainty.This change has occurred for two general reasons. First, economists now recognize that we lack a generally accepted and well-corroborated theory of exchange rates and exchange-rate systems. Most also recognize that we lack a good theory of the real effects of monetary shocks, systematic monetary policies, and overall monetary systems and institutions. Second, the evolution of the underlying macroeconomic theory has shifted attention to these newer factors. Still, nations must adopt some form of exchange-rate systems even in the face of uncertainty about key economic issues. Nations face the problem of policy making under uncertainty about the effects of their policies.

The main arguments for pegged exchange rates fall into three categories: 1. The traditional arguments that nations with similar economic structures that experience similar exogenous shocks can benefit from a common currency or a fixed exchange rate. 2. The argument that pegging the exchange rate provides credibility and perhaps a commitment to monetary policy. 3. Arguments that floating exchange rates reflect largely non-fundamental noise so that a floating-rate system creates variability, uncertainty, and over or under-valuation of currencies.

The biggest advantages come from the effect it has on a country’s exports and trade, especially between a nation with low production costs and another country with a stronger currency. A richer, more mature nation may choose to produce its goods in a less mature nation, where production costs are smaller. When those less mature nations translate their earnings into their domestic currencies, they make a larger profit, creating a win/win situation for both countries.

A pegged exchange rate also supports a rising standard of living and economic growth. And it protects a nation from volatile swings in the foreign exchange rate, which reduces the likelihood of a currency crisis. Among the disadvantages is the large amount of reserves a central bank has to maintain to make a pegged exchange rate work.

The existence of a credible fixed peg regime had a positive impact on bilateral trade. • The more credible the peg, the higher its impact on bilateral trade. • The longer a fixed peg remained in place, the more it benefited trade. • Sharing a currency did not lead to more trade in the examined countries. This result, albeit counterintuitive, can be explained by the unique characteristics of the countries in the sample that shared a common currency, as they display mostly similar comparative advantages that create little incentive to trade among themselves.

1. b)The Euro is not only used in the 19 countries of the eurozone but also in some 22 countries and territories that do not belong to the EU have currencies that are directly pegged to the Euro . The Euro has even become an alternative to United States dollar. Presently it has become the second international reserve currency and used by central banks all over the world . As a result of the Euro exporting and importing goods and services to and from other EU countries frequently carry no costs of using different exchange rates . Furthermore, it enabled common same monetary policies carried out by the European Central Bank. The costs of capital are comparable for most EU countries: interest rates are quite similar with higher rates in some member countries reflecting country risks.It has contributed to lower costs of trading in the Eurozone and indirectly in the European Union. The Euro as a currency will probably exist for a long time. It will certainly survive. Not only because of the advantages mentioned above but also because leaving the Euro is practically impossible for its member countries. The loss of trust and security will immediately become evident for the leaving country, as its credit rating will fall and creditors will leave the country. Higher interest rates, a deterioration in both the current account and the capital account of the balance of payments and a huge reduction in national income is the price to be paid. This is apart from worse trading relations with its European neighbors.