International Business 13th Edition by Donald Ball,Michael Geringer,Michael Minor ,Jeanne McNett

Exercise 9

Debate: Fixed FX Rates, Perhaps Hooked to Gold, or Floating Rates, Hooked to Faith?
Most economists support the idea that floating exchange rates are beneficial for the world economy. A small minority of experts advocates a return to the gold standard and fixed exchange rates. Let's further consider this choice.
In the early 1970s, the U.S. government could not continue to guarantee that dollars floating around the world would be convertible to gold at the agreed rate. So, the U.S. decoupled the dollar from gold, with the immediate effect that the world's currency exchange rates were not fixed any more. a
The economists, Obstfeld and Rogoff, argue that the main reason exchange rates could not stay fixed was the rapid evolution of world capital markets since the 1950s. Because the volume of global transactions started exceeding most countries' foreign exchange reserves, governments could no longer intervene effectively to sustain the value of their currency. Until the volume of trade grew, governments would buy or sell significant amounts of their currencies in the global markets in an effort to sustain their currency's supply and demand equilibrium. At the same time, a speculative attack on a specific currency by the "market" could cause a run on a currency that a government could not counter. As we have already seen, with the advent of the Internet, in less than 15 years the amount of daily foreign exchange transactions has increased from $1 trillion in 1994 to more than $4 trillion in 2010. Thus, it is difficult to imagine the day when the main currency regimes around the world would be dominated by fixed rate relationships.
Even if a central bank could support its currency effectively, the impact on the rest of the economy could be considerable. In this chapter, we have discussed the relationship between exchange rates and interest rates. In an environment where currency A is becoming relatively stronger than currency B, the interest rates in country A are likely to be higher than those in country B. This increases the cost of doing business in country A versus country B. Moreover, interest rate movements, exchange rate values, and inflationary pressures tend to be interlinked. Finally, the role of speculators cannot be overlooked. The currency market impressions of a currency's reputation can be enough to scare buyers away from a perceived weak currency toward a strong one. As with any other buying-selling relationship, this will weaken further the currency that buyers are fleeing from and strengthen the one they are going to. Then, the strengthening currency has a negative impact on that country's ability to export.
The discussion up to here shows that we may not like "floating exchange rates" for whatever reasons, but is there an alternative in today's globalized economy and global capital markets? What are the key arguments for trying to "fix" exchange rates? Two are as follows: b First, exchange rate changes increase the risk and cost of trade for industries that are based on producing goods. These industries have products that have to be shipped from one country to another. This process is associated with a time lag from when an order is placed, to when the producer ships, to when the buyer receives a product. These three points in time may be associated with very different exchange rates among the currencies of the two countries involved. Whether it is the manufacturer or the buyer or both who bear the risk, there are ways to minimize foreign exchange risk related to timing. All these ways introduce a new cost to the transaction. Had the exchange rate been fixed, this cost would not arise.
Second, exchange rate fluctuations may lead to protec-tionist measures that can impede trade and deprive a country's people from trade benefits. Yet, fixing the exchange rate means that the government is also depriving itself of the ability to manage its monetary policy. Finally, fixed-rate proponents say that fixed exchange rates impose monetary discipline on a government. A long, logical explanation shows, however, that this implies isolation from actions of other governments, an impossible option today.
Given the preceding discussion, what is your own broad conclusion about the viability of fixed or floating exchange rates?