Question

Discuss the arguments that favor a floating exchange rate system against a fixed exchange rate system. Present the common arguments that favor fixed exchange rates. Give specific examples to illustrate your comprehension and application of the topic.

Answer 1

Under fixed exchange rate system, exchange rate of the currency with other currencies is fixed by the government. Floating exchange rate system is based on exchange rate being determined by the market forces of demand and supply for currencies traded by global participants. When there is a fixed exchange rate regime, there is a less speculation because market participants consider the government action as credible and predictable. In contrast under a floating exchange rate regime, there is the high speculation because the central bank does not regularly interfere to maintain the exchange rate, there is a risk of speculative attack. Fixed exchange rate ensures stability in the international forex market and money market because government is committed towards maintaining the exchange rate. Over under the flexible exchange rate, there is continuous fluctuation in the exchange rate and high instability. Fixed exchange rate encourages trade because there is reduced currency risk. This is not endorsed by flexible exchange rate where there is a higher foreign exchange risk. Fixed exchange rate discourages venture capital but the same is encouraged by the floating exchange rate in the international market. Fixed exchange rate is supported by international reserve which are required to be maintained. Floating exchange rate are not supported by international reserves

Below is an example of how the two regimes work. Here, government spending is reduced. When the government reduces its spending, Consumption and investment fall and thus the IS shifts to the left. This causes the interest rate to fall. The economy has a flexible exchange rate system, when interest rate falls below the world interest rate, capital outflows occurs, this depreciates the exchange rate. With depreciated currency, exports are increased and imports are reduced. Trade surplus increases the income so that it reaches back to its original level. Figure A-1 Figure A-2 LM Exchange rate, el LM LM Exchange rate, e - QA VA IS 1S2 - IS - IS2 Income and Output, Y YAY, Income and Output, Y In case of a fixed exchange rate regime reduced government spending help in lowering the interest rates. Consumption and investment fall and thus the IS curve shifts to the left. Now there is a fixed exchange rate system, when exchange rate starts depreciating, central bank immediately intervenes and buys the surplus domestic currency to squeeze out the liquidity. LM, shifts to the left till the fixed level of exchange rate is determined.