disadvantages and advantages of exchange rate.
normal exchange rate.
not fixed or flexible.
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Advantages and disadvantages of fixed exchange rates
Advantages of fixed exchange rates
Certainty - with a fixed exchange rate, firms will always know the exchange rate and this makes trade and investment less risky.
Absence of speculation - with a fixed exchange rate, there will be no speculation if people believe that the rate will stay fixed with no revaluation or devaluation.
Constraint on government policy - if the exchange rate is fixed, then the government may be unable to pursue extreme or irresponsible macro-economic policies as these would cause a run on the foreign exchange reserves and this would be unsustainable in the medium-term.
Disadvantages of fixed exchange rates
The economy may be unable to respond to shocks - a fixed exchange rate means that there may be no mechanism for the government to respond rapidly to balance of payments crises.
Problems with reserves - fixed exchange rate systems require large foreign exchange reserves and there can be international liquidity problems as a result.
Speculation - if foreign exchange markets believe that there may be a revaluation or devaluation, then there may be a run of speculation. Fighting this may cost the government significantly in terms of their foreign exchange reserves.
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Advantages and disadvantages of fixed exchange rates
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Advantages of fixed exchange rates
1. Avoid currency fluctuations.
If the value of currencies fluctuates, significantly this can cause problems for firms engaged in trade.
- For example, if a firm is exporting, a rapid appreciation in Sterling would make its exports uncompetitive and therefore may go out of business.
- If a firm relies on imported raw materials, a devaluation would increase the costs of imports and would reduce profitability.
2. Stability encourages investment.
The uncertainty of exchange rate fluctuations can reduce the incentive for firms to invest in export capacity. Some Japanese firms have said that the UK’s reluctance to join the Euro and provide a stable exchange rate makes the UK a less desirable place to invest. A fixed exchange rate provides greater certainty and encourages firms to invest.
3. Keep inflation low.
Governments who allow their exchange rate to devalue may cause inflationary pressures to occur. Devaluation of a currency can cause inflation because AD increases, import prices increase and firms have less incentive to cut costs.
- AD increases (higher demand for exports), import prices increase, and firms have less incentive to cut costs.
- Import prices increase.
- Firms have less incentive to cut costs.
A fixed exchange rate, by contrast, means firms have an incentive to keep cutting costs to remain competitive.
It is hoped a fixed exchange rate will reduce inflationary expectations.
4. Current account.
A rapid appreciation in the exchange rate will badly affect manufacturing firms who export; this may also cause a worsening of the current account.
Disadvantages of fixed exchange rates
1. Conflict with other macroeconomic objectives.
- To maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives.
- If a currency is under pressure and falling – the most effective way to increase the value of a currency is to raise interest rates. This will increase hot money flows and also reduce inflationary pressures. However higher interest rates will cause lower aggregate demand (AD) and lower economic growth, If the economy is growing slowly this may cause a recession and rising unemployment.
2. Less flexibility.
In a fixed exchange rate, it is difficult to respond to temporary shocks. For example, if the price of oil increases, a country which is a net oil importer will see a deterioration in the current account balance of payments. But in a fixed exchange rate, there is no ability to devalue and reduce current account deficit. Sterling was in the ERM between 1990 and 92. But, left in Sept 1992, causing large devaluation.
3. Join at the wrong rate.
It is difficult to know the right rate to join at. If the rate is too high, it will make exports uncompetitive. If it is too low, it could cause inflation. In the late 1980s, the UK chancellor, Nigel Lawson tried to shadow the DM and keep Sterling low; this led to a rise in inflation. In 1990, the UK joined the ERM, but the rate proved too high and trying to keep the value of the Pound high led to high-interest rates and the recession of 1991/92.
4. Require higher interest rates.
If the currency is falling below the exchange rate floor, the government may be forced to put up interest rates – even if this is unsuitable for the economy. For example, in 1992, the government was trying to keep Pound Sterling in the ERM, but the value was falling. Therefore, the government increased interest rates to 15% – but this was very damaging – causing mortgage defaults and the recession of 1991/92