List and explain the difficulties associated with exchange controls.

Question

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The Answer is If one does not fully examine the implications of exchange controls, it initially seems to be a plausible method of fixing a country's exchange rate. However, as a practical matter, exchange controls tend to cause a number of economic difficulties. First, there is the simple annoyance of dealing with a government bureaucracy. The government must sell or buy all foreign exchange earned and requested by residents and firms within the country. As the government is the sole source of foreign exchange, this type of bureaucracy is unlikely to provide the same quality service as a free market. A more serious difficulty arises with respect to the difference between the nominal exchange rate and the real exchange rate. When a country fixes an exchange rate, the exchange rate is expressed in nominal terms. So long as the nominal exchange rate is close to its purchasing power parity value, then a nominal peg may be sustainable over time. If the real exchange rate depreciates while the nominal exchange rate is held constant, then the nominal exchange rate becomes overvalued and a shortage of foreign exchange will result. To balance the demand and supply of foreign exchange, the government can use one of three options. First, the government could allow the currency to depreciate. Second, the government could implement restrictive macroeconomic policies (contractionary fiscal and/or monetary policy) that would reduce the demand for foreign exchange. The third and most common option available to the government is to ration the available supply of foreign exchange. Since the quantity demanded is greater than the quantity supplied, the government must decide who will get foreign exchange and who will not.

List and Explain the Difficulties Associated with Exchange Controls