Pros/Cons of Fixed and Floating exchange rates? (1 Viewer)

[buddyhield]

I'm not really sure about the pros/cons of fixed and floating exchange rates.

Any help would be appreciated.

 

[BLIT2014]

Floating Exchange Rate:

Advantages:

(1) Set a more realistic market price for the currency
i.e better reflects the fundamentals of the Australian economy

(2) Discourage speculation on the the future value of the currency

(3) Enables the Australian Government to have a more effective and independent monetary policy

(4) Provides some insulation properties for Australian economy from financial/external shocks.
i.e can move to new equilibrium positions, and provides signals to exporters/importers and government that structural change was necessary.

(5) Allows for greater global market integration + Consistent with systems used by major trading partners.


Disadvantages

(1) Greater volatility

(2) Subject to sudden shifts in market sentiment

 

[BLIT2014]

Fixed Exchange Rates

Advantages

(1) Eliminates uncertainty and risk

(2) Speculation may be deferred

(3) Prevention of depreciation of currency

(4) May force government to adopt responsible Macroeconomic policy

(5) Can attract FDI

(6) Anti-Inflationary in nature

Disadvantages

(1) Encourages speculation

(2) Government will have to sacrifice employment and growth policies

(3) Leads to decrease in global market integration

 

[elkedag]

Fixed Exchange Rates

Advantages

(6) Anti-Inflationary in nature

This may not necessarily be the case. Recall the economic trilemma / impossible trinity model, where macroeconomies will usually use the money supply in order to fix the value of the currency, thus foregoing it as a tool to effect monetary policy - this may be inflationary if, for instance, a supply shock cannot be mitigated with monetary policy - this may induce a Cagan hyperinflation if inflationary expectations cannot be controlled.

Fixed Exchange Rates

Disadvantages

(1) Encourages speculation

Perhaps a bit imprecise, as an unchanging value for a currency isn't a major drawcard for speculation. A large majority of FOREX transactions with the AUD are speculative anyway. What may be a more significant risk to the economy is that a speculative attack creates a positive feedback loop for fixed exchange rates - if a currency is fixed higher than its fundamental value and there is a flight from the currency due to a perceived risk of a lack of reserves, this will accelerate the loss of reserves as Central Banks must sell them to fill the shortfall in demand at the fixed price.

 

[BLIT2014]

This may not necessarily be the case. Recall the economic trilemma / impossible trinity model, where macroeconomies will usually use the money supply in order to fix the value of the currency, thus foregoing it as a tool to effect monetary policy - this may be inflationary if, for instance, a supply shock cannot be mitigated with monetary policy - this may induce a Cagan hyperinflation if inflationary expectations cannot be controlled.



Perhaps a bit imprecise, as an unchanging value for a currency isn't a major drawcard for speculation. A large majority of FOREX transactions with the AUD are speculative anyway. What may be a more significant risk to the economy is that a speculative attack creates a positive feedback loop for fixed exchange rates - if a currency is fixed higher than its fundamental value and there is a flight from the currency due to a perceived risk of a lack of reserves, this will accelerate the loss of reserves as Central Banks must sell them to fill the shortfall in demand at the fixed price.

I should probably have expanded on my points.

 

[buddyhield]

I should probably have expanded on my points.

does an increase in international competitiveness (of Aus exporters) result in appreciation or depreciation?

also does does an increase in international competitiveness (of Aus exporters) result in a high or low exchange rate?

 

[buddyhield]

This may not necessarily be the case. Recall the economic trilemma / impossible trinity model, where macroeconomies will usually use the money supply in order to fix the value of the currency, thus foregoing it as a tool to effect monetary policy - this may be inflationary if, for instance, a supply shock cannot be mitigated with monetary policy - this may induce a Cagan hyperinflation if inflationary expectations cannot be controlled.



Perhaps a bit imprecise, as an unchanging value for a currency isn't a major drawcard for speculation. A large majority of FOREX transactions with the AUD are speculative anyway. What may be a more significant risk to the economy is that a speculative attack creates a positive feedback loop for fixed exchange rates - if a currency is fixed higher than its fundamental value and there is a flight from the currency due to a perceived risk of a lack of reserves, this will accelerate the loss of reserves as Central Banks must sell them to fill the shortfall in demand at the fixed price.

does an increase in international competitiveness (of Aus exporters) result in appreciation or depreciation?

also does does an increase in international competitiveness (of Aus exporters) result in a high or low exchange rate?

 

[BenHowe]

does an increase in international competitiveness (of Aus exporters) result in appreciation or depreciation?

also does does an increase in international competitiveness (of Aus exporters) result in a high or low exchange rate?

For both of them you just need to think about it logically. I think that this is best done by using a exchange rate diagram (effectively S/D). So if the international competitiveness increases of Australian exporters this means that effectively their productivity or their given amount of output for the same level of input has increased. This means that the supply of the good increases. This increased supply will not only result in an increase export expenditure and subsequently an increase in the BOGS but will to some extent decrease the amount of imports purchased by the domestic economy, since the domestic firm is now able to compete on the most important component of a good/service, price. This results in an increase in credits and a decrease in debits and the supply of AUD falling and thus the exchange rate relative to a given currency will appreciate.

Well since Australia has effectively a floating exchange rate minus the RBA interfering with market forces to improve liquidity prior to FDI or "dirtying the float", the exchange rate is considered an automatic stabiliser, alebit in the long term. For example post GFC when China purchased AUS commodities, this increased the demand of the AUD and subsequently appreciated the currency. However this meant that the relative purchasing power of the AUD increased and provided a greater incentive for consumers to spend their AUD O/S as effectively if say the AUD to US was 1.2:1 during the era of parity in the mining boom, this meant that effectively if the US if was considered to be a store, it was having a 20% off sale. This resulted in a large outflow of AUD to O/S i.e. people travelling to Europe or purchasing sporting apparel from Eastbay in the US. Anyways this outflow of AUD resulted in an increased supply of AUD on the FOREX and thus depreciated the currency etc.

One thing to add for fixed exchange rates is that for a lot of economies it just isn't feasible due to the specialisation of economies, to be ‘fixed’. This is because a large amount of capital and/or money is required to artificially manipulate the exchange rate. For example, China, despite the recent negative media attention on government regulation of the financial sector, is one of the few economies who effectively controls their exchange rate. In the post GFC period when they purchased AUS commodities such as iron ore to produce steel for infrastructure projects, this resulted in the Yuan falling. However the government wished to keep their currency at a given price, so their sold A LOT of foreign currency for Yuan. Thus increasing the supply of the currency of other economies and decreasing the supply of the Yuan. This results in an appreciation of the currency. Note this requires A LOT of capital, given the size of modern day economies.

The real reason China is able to effectively do this is (just remembered) is because they are one of the few economies with a surplus in the CA, primarily due to the large income credits they receive for the manufacturing industry. So this means they and the government have access to a large amount of capital (mainly money) that they can utilise without accumulating the debt that an economy with a CAD such as Australia would accumulate. This outcome is also amplified given the high levels of Chinese household saving and thus makes it feasible to have a fixed exchange rate.

In case I didnt specify it in terms of the foreign exchange market supply represents those who are willing and able to 'sell' their domestic currency. Whereas demand represents those who are willing and able to purchase that domestic currency.

Hope this helps