The value of a currency against another can be severely diminished in a single trading day. This is because as exchange rates change so does the benefit that can be derived from resources. Also, since Forex market is not regulated, currency values could skyrocket or hit rock bottom in a matter of minutes. It is difficult to know the right rate to join at. As globalization has progressed, more countries have abandoned their currency pegs and have allowed their currencies to freely float. Floating exchange rates provide freedom in terms of domestic economic policy since the central bank is not forced to meet a certain exchange rate by using interest rate which if used for another purpose might undermine the entire purpose of using fixed rate. Advantages of fixed exchange rates 1.
The choice between these two systems is therefore an ideological choice. They however lose the ability to manage their inflation, interest rates etc because the only way a fixed exchange rate works is that they mimic exactly the interest rates etc of the base currency which is usually the euro or dollar in most cases. Fixed exchange rates can lead to current account imbalances. The floating rate allows governments freedom to pursue their own internal policy objectives such as growth and full employment without external constraints. The uncertainty of exchange rate fluctuations can reduce the incentive for firms to invest in export capacity. The supply of the currency is high, since the demand for imports is relatively high. Yet, this has not always been the case in the past.
Currency Loosely Fixed These countries fix their currencies to a trading range tied to either a single or a basket of currencies. Planning of businesses tends to be difficult and investments, defined as the expenditure by firms on capital equipment and is an injection into the economy, are hard to assess. And if we add imports, this proportion doubles to 80 per cent. However, on the other hand, floating exchange rate system does not guarantee many things for businesses. Adverse Effect on Economic Structure: The system of flexible exchange rates has serious repercussion on the economic structure of the economy.
On the other hand, in the flexible exchange rate system, the decrease in currency price is regarded as depreciation and increase, as appreciation. It ties the value of its currency, the , to a basket of currencies including the dollar. That there is such interest in our exchange rate is hardly surprising. Indeed, there have been times when economic shocks and policy differences in the two countries have worked in the opposite direction, leading to increases in the value of the Canadian dollar. Therefore, Hong Kong goods will be less expensive to Japanese importers. How could such an effect on the dollar increase the probability that the U.
This will help restore the competitiveness of exports. Is there reason for me to believe otherwise? Such an expectation causes bond portfolio managers to liquidate some of their bond holdings, thereby causing bond prices to decline immediately. Instead, it can just passively manage the currency by setting important rates and interfering in the market only when it becomes necessary. Disadvantages of the Floating Rate Uncertainty — The fact that a currency changes in value from day to day introduces instability or uncertainty into trade. In a floating exchange rate regime, the macroeconomic fundamentals of countries affect the exchange rate in international markets, which, in turn, affect portfolio flows between countries. To purchase French pastries, the Saudis pay less than they did before the. Conversely, a balance of payments surplus should be eliminated by an appreciation of the currency.
Japanese goods become more expensive to U. If there were any perceived risk of a future devaluation of the fixed rate for the Canadian dollar, the result would be persistently higher interest rates in Canada than in the United States to compensate for that risk. There are seven countries in Central Africa that use the Central African franc. Fixed exchange rate system offers stability, strong incentive for inflation control and some immunity against speculation. Fixed exchange rate and flexible exchange rate are two exchange rate systems, differ in the sense that when the exchange rate of the country is attached to the another currency or gold prices, is called fixed exchange rate, whereas if it depends on the supply and demand of money in the market is called flexible exchange rate.
They are: Cameroon, Central African Republic, Chad, Equatorial Guinea, Gabon, and Republic of the Congo. Why do you think Central Banks might prefer a managed exchange rate system over a fixed or a floating exchange rate? These reserves can therefore be fruitfully used to import capital goods and other items in order to promote faster economic growth. In Canada, the debate about exchange rate regimes has been mainly among academic economists. This does not mean that our floating exchange rate regime has somehow outlasted all its critics! So, yes, there are certain transactions costs in having a separate currency. Different Exchange Rate Systems Different Exchange Rate Systems.
On the face of it, of course, a currency union would be better than dollarization. It is then that the speculators see an opportunity to bring the currency to its equilibrium point quickly and make a quick buck by doing so. The monetary policy of a country is not limited or affected by the economic conditions of other countries. However, the central bank that devalued a currency by giving out too much of it would soon either stop or run out of it. Under a freely floating system, government intervention would be non-existent, and exchange rates are determined solely by market forces. This will place an upward pressure on the foreign currency.
A weak dollar would make the U. In this way, fiscal discipline is imposed on the economy. Under the circumstance, speculators go on buying home currencies where exchange rates have been reduced. A seller may not be quite sure of how much money he will receive when he sells goods abroad. Conclusion As both the exchange rate system have their positive and negative aspects. The greatest advantage is that adjustments needed to achieve external equilibrium impact only indirectly on the domestic economy.
Therefore, floating exchange rate regimes enhance market efficiency. Within a few days after the September 11, 2001 terrorist attack on the U. The sterling block functioned smoothly during the thirties in spite of the fluctuating rates of the member countries. Thus, the possibility of international monetary crisis originating from exchange rate changes is automatically eliminated. The exchange rate that variates with the variation in market forces is called flexible exchange rate.