4.16 - Fixed & Floating Exchange Rates
Advantages of floating exchange rates
Floating exchange rates allow the value of a currency to be determined by market forces, without direct government intervention. This system provides several benefits for economic management and international trade.
Benefits for monetary policy and economic adjustment
- Freedom in monetary policy - Governments can adjust interest rates to meet internal economic targets, such as stimulating growth through lower rates, which may lead to currency depreciation and higher net exports, or controlling inflation with higher rates, causing appreciation and reduced net exports.
- Self-correcting trade balances - Persistent trade deficits can resolve naturally as excess currency supply in foreign markets causes depreciation, making exports more competitive and imports more expensive, provided the Marshall-Lerner condition holds.
- Gradual market adjustments - Exchange rate changes occur steadily, minimising the risk of sudden economic shocks or crises.
- Lower reserve requirements - Central banks avoid the need for substantial foreign currency holdings, as they do not regularly buy or sell to maintain fixed values.
Disadvantages of floating exchange rates
Despite their flexibility, floating exchange rates introduce volatility that can hinder economic stability and planning.
Challenges from volatility and policy freedom
- Increased uncertainty for trade and investment - Frequent and unpredictable rate changes make it difficult for businesses to forecast costs or revenues, potentially reducing international trade and foreign investment.
- Potential for lax economic policies - Governments might pursue overly expansionary measures to boost short-term output, leading to higher inflation without the discipline imposed by fixed rates.
- Vulnerability to speculative attacks - If market sentiment turns negative due to weak economic indicators, speculators can amplify currency falls, causing sharper depreciations than fundamentals would suggest.
Advantages of fixed exchange rates
Fixed exchange rates involve pegging a currency's value to another currency or a basket of currencies, offering stability that supports long-term planning.
Benefits for stability and efficiency
- Enhanced predictability - Stable rates enable firms to better anticipate export earnings and import expenses, encouraging higher levels of trade and cross-border capital movements.
- Promotion of policy restraint - The need to maintain the peg discourages inflationary spending, helping to achieve price stability, which is particularly useful in economies prone to high inflation.
- Encouragement of competitive practices - Businesses must focus on improving productivity and efficiency to stay competitive, as they cannot depend on depreciation to lower export prices.
Disadvantages of fixed exchange rates
Maintaining a fixed exchange rate can restrict a government's ability to respond to economic challenges and impose significant costs.
Limitations on policy and adjustment mechanisms
- Restricted economic tools - Authorities cannot freely use interest rates or exchange rate adjustments to address domestic issues like unemployment or growth slowdowns.
- Constraints on government spending - Large budget deficits may force monetary expansion or rate hikes, both of which conflict with holding the exchange rate steady.
- Abrupt and disruptive changes - When adjustments are needed, such as devaluation or revaluation, they happen suddenly, potentially causing economic instability.
- Difficult correction of trade imbalances - Without automatic depreciation, addressing deficits requires reducing overall demand, which can lead to lower output, economic contraction, and rising joblessness.
- Costly reserve holdings - Central banks must keep large stocks of foreign currencies to defend the peg, tying up resources that earn minimal returns and creating opportunity costs.
How were these notes?