Question

The economy of Fixiton has a fixed exchange rate which is overvalued. What is one reason why Fixition would have an overvalued exchange rate? Explain two methods of keeping the exchange in Fixiton fixed? What is one problem with each method?

Answer 1

An overvalued exchange rate implies that a countries currency is too high for the state of the economy. An overvalued exchange rate means that the countries exports will be relatively expensive and imports cheaper. An overvalued exchange rate tends to depress domestic demand and encourage spending on imports.

An overvalued exchange rate can also be measured by looking at purchasing power parity PPP. An overvalued exchange rate will mean goods are relatively more expensive in that country. (a more sophisticated form of PPP also takes into account difference in real GDP per capita – Beefed up Big Mac Index at Economist)

An overvalued exchange rate is particularly a problem during a period of sluggish growth. If the economy is booming, an overvalued exchange rate can help reduce inflationary pressure, but in a recession, an overvalued exchange rate can cause further deflationary pressures.

Fixing, or pegging, a currency to another results in a constant exchange rate. In Switzerland's case, the country set the value of its currency at 1.2 Swiss francs per euro

To make a peg work, a country's central bank must continually buy and sell its own currency on foreign exchange markets in return for the currency to which it is tied.

The downside, of course, is that countries with fixed exchange rates forfeit control of their monetary policy. That makes them more susceptible to financial shocks elsewhere in the world and can lead to more frequent and aggressive attacks by speculators. Countries with fixed exchanges must essentially embrace the monetary policies of their currency sponsor.

There was a time – nearly 40 years ago – when virtually all currencies were fixed to the value of gold. The Bretton Woods regime broke down in the 1970s as countries found it increasingly difficult to maintain the strict financial discipline needed to keep their currencies fixed amid a surge in global commodity prices.

Efforts since by countries to return to pegged currencies have generally failed. Argentina, Mexico, Greece and Thailand are among the most spectacular failures.

And it has often led to problems when smaller countries tie their fortunes to larger ones. Studies have shown that small countries with pegged currencies suffer from higher unemployment, lower consumption and, ultimately, lost wealth.

There are generally two ways in which countries can value their currency in the world market. They can either fix their currency to gold or to another major currency, like the U.S. dollar or the euro. Alternatively, they can let their currency float in the world market.

If the exchange rate is fixed, the country’s central bank, or its equivalent, will set and maintain an official exchange rate. To keep this local exchange rate tied to the pegged currency, the bank will buy and sell its own currency on the foreign exchange market in order to balance supply and demand.

A fixed exchange-rate system can also be used to control the behavior of a currency, such as by limiting rates of inflation. However, in doing so, the pegged currency is then controlled by its reference value. As such, when the reference value rises or falls, it then follows that the value(s) of any currencies pegged to it will also rise and fall in relation to other currencies and commodities with which the pegged currency can be traded. In other words, a pegged currency is dependent on its reference value to dictate how its current worth is defined at any given time. In addition, according to the Mundell–Fleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy to achieve macroeconomic stability.