Question

What are the pros and cons of each exchange rate regime? If a country uses a fixed exchange rate, what limitations are placed on its monetary policy or international capital flows (the Impossible Trinity)? Why?

Do you think the US should remain on a flexible exchange rate system or move to a pegged system? If the latter, which currency should the US dollar be pegged to?

Answer 1

As we know an exchange rate regime is related to monetary policy of the country.

Basically, there are three types of EXCHANGE RATE.

1)Floating Exchange

2)Fixed Exchange

3)Pegged Float

Pros and Cons of Floating Exchange- a) Automatic stabilisation - It automatically correct the disequilibrium in the balance of payment by the change in the exchange rate.

b)Freeing Internal Policy-By changing the external price of the currency, Balance of payment deficit of a country can be rectified.

c) Absence of Crisis-Under floating exchange system, such changes occur automatically. Therefore the possibility of , international monetary crisis originating from exchange rate changes is automatically eliminated.

Cons of Floating Exchange- a)Uncertainty-its so flexible in nature gives uncertainty into trade.

b)Lack of Investment- Due to high uncertainty in floating exchange, it discourages the Direct foreign Investment.

Fixed Exchange Rate Pros and cons- a) Certainty - its gives higher certainty to exporter and importer, due to which it attracts to direct foreign investment.

b) It helps government to maintain the low inflation,Which has positive long term effect to keep the down interest rates.

Pegged Floating Rate Pros and Cons- taking both pros and cons of Pegged exchange rate, one can see both major and minor can favor such policy.By pegging its currency, a country can gain its comparative trading advantages while protecting its own economic interests.

If a country uses a fixed exchange rate, what limitations are placed on its monetary policy or international capital flows (the Impossible Trinity)? Why?-

If a country uses the fixed exchange rates, it helps to attract direct foreign investors, because it has high certainty. Again it helps a country to keep the low inflation in long run.

To maintain a fixed level of exchange rate may conflict with other macroeconomic objective, however higher interest rates cause lower aggregate demand and lower economic growth,, this situation slow down the economic growth, it causes the recession and rising unemployment..It gives impact in supply and demand and in contrast, if a country imports more than its exports, there is relatively less demand for its currency, so value of the currency decline.

Do you think the US should remain on a flexible exchange rate system or move to a pegged system? If the latter, which currency should the US dollar be pegged to?-

They and a floating exchange rate.