Deck 27: Fixed or Flexible Exchange Rates

Question 1

What alleged disadvantages of a fixed-rate system are still present in the proposal for wider bands around parity?

Answer 1

Discipline in the world economy mean a set of rules for best practice. This can be policy actions regarding financial institutions, this working, corporates etc. This assures smooth working of the economy minimizing the shocks.
There are two types of exchange rates; names are fixed exchange rate and flexible exchange rate.
In fixed exchange rate system a country's currency value is fixed or pegged to another country's currency value. It is also known as pegged exchange rate whereas in floating exchange rate or flexible exchange rate system a country's currency value is determined by the demand and supply forces in the world market.
In economic policy the main aim is to present continuous inflation. In this case fixed exchange rate would be helpful. A country's inflationary presence will not rise alone as compared to the rest of the world. When a country faces BOP deficit situation, then fixed exchange rate will lead the anti-inflationary policy to control the situation of inflation. When fixed exchange rate system exist inflationary pressure are not as high as in case of flexible exchange rate system. Flexible exchange rate system fuels the inflationary pressure.

Question 2

What is meant by "discipline" in the world economy, and how might fixed exchange rates work to promote such discipline?

Answer 2

Wider bands are a term related to currency bond. Currency bond specifies the upper and the lower price limits of a currency which is stated by a government. Wider bands means larger variations around parity are allowed. Bands are used as monetary policy during exchange rate volatility. It controls the impact of speculation in exchange rates.
Under fixed rate even if there is wider bands there are some disadvantages associated with it. This can be explained as follows -
(i) If both the countries have different rates of inflation, say one country experiencing high rates of inflation but the other one is not then the fixed exchange rates would provide demerits.
(ii) When a country's exchange rate rises too much then destabilizing speculation can occur.
(iii) There can be a movement of wasteful resource under fixed exchange rate system when there is wider band around parity.
(iv) These will be needed to hold international reserves where opportunity costs are involved.
(v) Business cycles fluctuations will be spilled over internationally.
This there are some disadvantages associated with this system.

Question 3

Is the adoption of a fixed exchange rate system a guarantee that destabilizing speculation will not occur? Why or why not?

Answer 3

People will sell a foreign currency when its rate falls in expectation that the rate will fall further. It also refers to the situation when people purchase foreign currency when its rate falls in expectation that the rate will rise afterwards. This creates a destabilization in the economy.
But under fixed exchange rate system the exchange rate remains relatively stable. Therefore there is a less chance of speculation. If in case speculation arises then it will not be destabilizing in nature. This is because fixed exchange rate system will force the policy makers to undertake actions which will remove any adverse impacts of speculation. So any destabilization will be eliminated under fixed exchange rate system.

Question 4

Why does the presence of different country preferences on possible inflation-unemployment trade-offs pose a problem for a system of fixed exchange rates?

Question 5

Why is destabilizing speculation considered conceptually rather unlikely in a crawling peg system?

Question 6

Why might a fixed-rate system potentially enhance the growth of foreign trade and investment in the world economy?

Question 7

Explain how a sudden rise in the price level in foreign countries can be less inflationary for the home country in a system of flexible exchange rates than in a system of fixed exchange rates.

Question 8

What case can be made that flexible exchange rates reduce the flow of long-term foreign direct investment? What case can be made that flexible rates might actually lead to more foreign direct investment?

Question 9

How can the existence of the transactions and precautionary demands for international reserves reduce world output over what would otherwise be the case?

Question 10

Explain Mundell's point that a country may not be an optimum currency area.

Question 11

In what way might the relative susceptibility of a country to external shocks rather than internal shocks condition the choice between a fixed or flexible exchange rate for that country? Explain.

Question 12

Explain why it can be uncertain whether fiscal policy is more effective for influencing national income under fixed exchange rates than under flexible exchange rates.

Question 13

"If you believe that free markets maximize welfare, then you should also believe that a free exchange rate is an integral part of welfare maximization." Discuss.

Question 14

Must the adoption of a flexible exchange rate mean that the rate will actually vary considerably over time? Why or why not?

Question 15

Much discussion concerning floating rates stresses the risks to trade and investment involved with such a system. Is risk necessarily a bad thing? Why or why not?

Question 16

Does a currency board seem to be a useful, practical arrangement for a country? What factors seem critical for a currency board's success?

Question 17

Under what conditions would the world as a whole be an optimum currency area? Do you think that the industrialized countries should be one optimum currency area and the developing countries another? Explain.

Question 18

"The hybrid systems combining fixed and flexible exchange rates are merely ways of avoiding having to make a choice between a fixed rate and a flexible rate. These systems invariably involve the 'worst of both worlds.' " Discuss.

Question 19

In the early 1990s, the foreign exchange reserves of Chile increased dramatically as foreign investment flows into the country increased substantially because of the favorable investment climate and impressive economic growth. At the same time, Chile began intervening in foreign exchange markets to stabilize the exchange value of its peso. How might these two events be related to each other?

Question 20

Explain Mundell's distinction between a "true" currency area and a "pseudo" currency area. Why is this distinction important?