Exchange Rate Implications Assignment Help
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Exchange Rate Implications Assignment Help
This article takes the discussion of exchange rates one step further to see what are the consequences of taking a particular type of ER, that is fixed ER or floating ER. In particular, we look at the three dimensions of any exchange rate system: inflationary pressures, autonomy of monetary policy and risk and volatility.
We look at the exchange rate risk first, which is defined as the risk of losses caused due to a change in the exchange rate. Note that the exchange rate fluctuation is more probable in the floating ER system as the ER is meant to float in this regime, however, even the fixed ER system does not assure no fluctuations as the currencies can be devalued or revalued. From a trader’s point of view, the difference in the date of agreement of a selling contract and the date of receiving the actual payment can cause exchange rate risks and result into losses or fall in expected profits. From an investor’s point of view, the date of investing and the date of withdrawing the money can lead to an exchange rate risk. Note that the risk comes from potential changes in the ER, both in floating ER and fixed ER, however, the chances of fluctuations in floating ER may be higher a priori. However, IMF study in 2004 found that empirically both the systems are expected to fluctuate approximately equally and that these fluctuations do not cause much difference in international trade flows. The fixed ER fluctuation can also be understood by the fact that while the currency is fixed to one currency, it might well fluctuate w.r.t. other currencies.
Suppose the floating ER is in place and the government spending increases but taxes are not raised, leading to an increase in the fiscal deficit. After a point, the government has to monetize the debt by selling bonds to the central bank. This increases the money supply, and with the floating ER in place, leads to a depreciation of currency due to capital outflow caused by low interest rate. In the long run, inflation will increase if GDP growth is less than money supply growth. In this situation, a fixed ER will mean that the central bank will soak up the domestic currency to maintain the fixed ER and hence, the interest rate will stabilize over the period of time if the net increase in money supply matches the GDP growth rate. However, the BOP deficit takes place and it needs to be taken care of if the stability is to materialize. Fixed ER, however, may cause higher inflation if the reserve currency country’s inflation spills over to the other countries, as it happened in 1970s which lead to a dismantling of the Bretton Woods system. Few ways to tackle this situation is to have currency boards, dollarization and fixing the currency to another currency which is less likely to fluctuate much.
Choosing a fixed ER leads to a monetary policy paralysis, as we have seen in the last chapter. As the money supply increases, the interest rate falls leading to capital outflow and hence, forcing the central bank to absorb the domestic currency till the initial equilibrium is restored. However, in a floating ER, the central bank can increase the money supply freely, in order to boost investment by reducing the cost of borrowing; due to lower interest rate. But the fixed ER system gives the exchange rate policy option, which might be used effectively as studied in the last chapter. Furthermore, the effectiveness of independent monetary policy has much to do with the competence of the central bank as it may hurt the economy if the monetary policy is not prudent, the case of hyperinflation in Argentina in 1970s and 1980s serving as a good example. UK decided to retain its monetary autonomy and that was the reason why it stayed away from the Eurozone, as it would have given the control of the monetary policy of the country to the European Central Bank which has to take care of the interests of the entire Eurozone and this would have hampered the interests of the UK.
All the discussion above brings us to the all the all-important question: which system to choose, fixed ER or floating ER? We have seen in the past chapters that several types of exchange rates have been tried in the past and no one particular system has been better than the other. Regarding the fixed and floating ER comparison, the main trade off seems to be between the monetary autonomy and the control of inflation. Deciding the exchange rate system has a lot to do with the competence of the central bank’s prudence in conducting the monetary policy: if the monetary policy has been incompetent in the past, then it makes sense to opt for the fixed ER. However, the temptation of devaluation must be checked. On the other hand, a country confident of prudent monetary policy should go for the floating ER. In any case, the fiscal policy prudence is very importance as large deficits on the government’s part hamper the economy, irrespective of the ER regime.
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