Evaluation of exchange rate systems

1. Evaluation of exchange rate systems

2. Fixed Exchange Rates: Advantages • Favour business investments No uncertainty → easy to plan future investments No exch rate movements that alter relative prices • Favour international trade by making it possible to accurately compare prices among countries. • No room for speculation → more currency stability. Exception: when people believe that a country may devalue or revalue its currency.

3. Firms and gov more disciplined to keep inflation under control: • Firms: keep costs down so that domestic goods do not lose competitiveness • Government: if allows inflation to increase: ↓X and ↑M → AD↓ → possible recession and UE and BoP deficit

4. Fixed Exchange Rates: Disadvantages • Possibility of insufficient reserves to maintain the fixed exchange rate. • Difficult to handle external shocks (eg ↑oil price → deficit ). If reserves to correct deficit are not readily available, country must resort to protectionist measures, contractionary policies or exchange controls, with negative effects. • Policies to correct deficits conflict with domestic priorities and can cause a recession. Contractionary policy → ↓AD → ↓Y (↑UE) → ↓M

5. Increased protectionism reduces world trade and worsens global allocation of resources. • Exchange controls worsen global allocation of resources. The control by the gov of currency transactions: • Distorts trade patterns • Restricts consumer choice • Causes development of black market for foreign exchange • Speculation. If devaluation is anticipated (because of a large and persistent deficit), speculators may sell the currency, which worsens deficit and forces devaluation.

6. Floating exchange rates: Advantages • Automatic adjustment. Correction of deficits and surpluses in an automatic way. • No need to hold official reserves to intervene in foreign exchange markets. • No conflict between BoP objectives and domestic objectives. • Easy adjustment to external schocks. If oil price ↑ → value of currency↓, eliminating the deficit.

7. Floating exchange rates: Disadvantages • Speculation can be destabilizing: when currency is expected to depreciate, it does it further than otherwise. • Excessive exchange rate volatility. Large and abrupt changes cause problems for countries depending on X → risk of financial crises (MX, Thailand, Russia) → intervention by IMF. • Exchange rate fluctuations cause uncertainty for traders and investors → inability to plan for the future → negative effects on trade and investment flows.

8. Managed Float: the supporters’view • Allows countries some flexibility in carrying out domestic policies. • Allows economies to adjust more easily to shocks. • Offers governments the opportunity to prevent sudden and large exch. rate fluctuations. • Makes currency speculation more difficult as speculators ignore if and when a CB will intervene.

9. Managed Float: the critics’view • Cannot do enough to prevent large fluctuations, which especially damage countries dependent on X. • Not successful in eliminating large trade imbalances (US case) • Offers opportunity to cheat by undervaluing the currency and gaining unfair comparative advantage.

10. Single currencies / Monetary integration • A system of fixed exchange rates among the participating currencies but with no possibility ever of changing the value of one currency in relation to another. • Significant characteristic: a single Central Bank (the ECB in the case of the eurozone countries). • Monetary Union • Created in 1999 by 11 European countries: A, BE, FI, FR, G, IR, IT, L, NL, PT, SP. • 2001: GR; 2007: Slovenia; 2008: CY, MT

11. Convergence requirements: • Limiting inflation rate • Limiting budget deficit (T-G) to 3% of GDP • Limiting gov. debt to 60% of GDP • The ECB assumed the responsibility for monetary policy for all members.

12. Advantages • Eliminates exch rate risk and uncertainty → benefits for importers, exporters and investors → encourages trade and investment across boundaries. • Eliminates transactions costs, which encourages trade. • Encourages price transparency → easier for econ decision makers to see price differences quickly → promotes competition and efficiency. • Low inflation rates, which gives rise to low interest rates → more investment, increased output. • Promotes higher level of inward investment (from outsiders towards the member countries), due to absence of currency risk.

13. Promotes fiscal discipline, forced (in the EMU) by the convergence requirements: public finances, government spending and taxation policies. • Stronger influence in world affairs. • Opens the way for common decision-making and integrated economic policies in more areas.

14. Disadvantages • Loss of exch rates as a mechanism of adjustment. Currency depreciation/devaluation cannot be used to solve trade deficit problems or loss of competitiveness. • Loss of monetary policy as an instrument of economic policy. Monetary policy carried out by ECB to achieve price stability for the region as a whole. Individual countries unable to carry out their own monetary policy. • Fiscal policy constrained by convergence criteria: • Advantage for some (promotes fiscal discipline). • Restriction of the economic sovereignty of a country for others.

15. Monetary policy by the ECB will have different impacts on each member. • Loss of economic sovereignty. National gov and national CB no longer responsible for economic policy, but the ECB.

16. Adjustment mechanisms within EMU countries The following methods can be used to address regional problems: • Fiscal policy, although with limits imposed by convergence requirements. • Labour and capital mobility should work to even out differences between economically more and less advanced regions: for instance, labour will migrate to wealthier regions or capital could flow into poorer ones to benefit from lower costs. BUT: language and cultural barriers are obstacles to labour mobility.

17. Regional policies such as investment towards depressed region(s) could be implemented, but this would require an EMU-wide fiscal policy, which has not yet been implemented.