To what extent is a floating exchange rate better than a fix
The exchange rate, which is the external value of the domestic currency, can be implemented by two different systems. In a floating exchange rate system, the values of currencies are determined by demand and supply in the foreign exchange market, with no government intervention. In a fixed exchange rate system, the government intervenes to maintain the exchange rate with buying and selling its own currency, or the manipulation of interest rates.Most developed countries in the world today use the floating exchange rate system. Here, the exchange rate automatically adjusts so that the supply and demand of the currency are in equilibrium. This leads to a self-correcting balance of payments, eliminating deficits or surpluses. A rise in imports leads to an increase in the supply of pounds and the exchange rate falls, with the opposite effects for exports. This though, needs to be under the condition that the price elasticity of imports and exports are greater than one, which is not always the case depending on the industry or the nature of the good. I
In 1990, the pound joined the Exchange Rate Mechanism at a high value, fixing its value against other currencies within the ERM within a band. There is also no need for the central bank to keep foreign reserves. Foreign currency reserves were used and interest rates were kept high to keep the value of the pound within its band. There are so many market forces that affect the demand and supply for a currency that it is difficult for the government to prevent the value of the money going up and down. The biggest disadvantage is that governments must make intervention a priority and may undertake policies that damage the domestic economy. Speculation on future movements can lead to major changes in the rate, and the instability floating exchange rate brings may deter investment and trade. This system brings a constraint on domestic inflation, where firms strive for low inflation and control on costs, as the currency is not able to depreciate to offset the inflation. Fixed exchange rates provide stability for firms and households, which is more encouraging to investment and trade. Most governments at one time or another seek to "manage" the value of their currency through changes in interest rates and other controls. This put pressure on import prices and prevented a future fall in the exchange rate from reigniting inflation. Instability in floating exchange rates show little effects of deterring investment and trade, relatively to the severe effects that could happen with contradictory policies in a fixed system, such as the experience of the UK in 1992. For example, there may be a contradiction between falling demand for pounds and weak demand in the domestic economy. Speculation can also be prevented as the value of the exchange rate is fixed. However, imported inflation can be prevented whereas under a fixed exchange rate, higher prices will be passed on. In this case the government would have to increase interest rates to sustain the value of the currency, but this will lead to a greater slump in the domestic market.
Common topics in this essay:
,
Rate Mechanism,
exchange rate,
floating exchange,
rate system,
exchange rate system,
floating exchange rate,
exchange rates,
fixed exchange,
investment trade,
value currency,
fixed exchange rate,
exchange rate fixed,
fixed system,
instability floating exchange,
instability floating,
government intervention,
|
Acceptance Essays
