Governments Would Prefer A Fixed Exchange Rate Economics Essay

1.0 Introduction

The authorities of every state would ever appreciate the scenario where they can hold a fixed exchange rate as it frequently does this through its agent the Central Bank ; fixes the value of the currency to another currency such as the US dollar or United Kingdom pounds sterling. Official exchange rates are so normally quoted in footings of US dollars or lbs sterling. A good illustration is the authorities of Nigeria in the early 80 ‘s when the Federal authorities had a fixed exchange rate which was fixed with the UK lbs sterling, and so a lb was equal to a Naira. The federal authorities used the cardinal bank to throng in surpluss from circulation so as to accomplish its coveted consequence.

Some other states besides had this in topographic point and the same is being worked upon by the European Union with the usage of one currency for all states in the brotherhood ( EU ) . The currency used is the Euro. The chief involvement in such disposal is the ability to command and guarantee a steady system which would name for a regulated economic system.

1.1 Aim

The aim of this assignment is to discourse issues which would be mentioned below as they would impact certainty in international trade when all states adopt a fixed exchange rate. The issues include:

Types of exchange rate

How exchange rate alterations

Impact of exchange rate on the economic system both nationally and internationally

Understanding of fixed exchange rate from demand and supply position.

1.2 DEFINITION OF EXCHANGE Rate

Harmonizing to investorwords.com exchange rate is ‘Rate at which one currency may be converted into another. The exchange rate is used when merely change overing one currency to another ( such as for the intents of travel to another state ) , or for prosecuting in guess or trading in the foreign exchange market. There are a broad assortment of factors which influence the exchange rate, such as involvement rates, rising prices, and the province of political relations and the economic system in each state. This is besides known as rate of exchange or foreign exchange rate or currency exchange rate ‘ .

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1.3 TYPES OF EXCHANGE Rate

Exchange rate fundamentally has to make with the in agreement currency/amount/value that a state would a nog for transactionary motivations between its state and other states around the Earth for concern motivations. The following are the types that exist:

Topographic point Rate: This type applies to bringing of currency seen as ‘on the topographic point ‘ . In topographic point dealing the existent exchange of money for goods takes topographic point with lower limit possible hold. The topographic point rate is the value of currency under consideration at that really minute.

Forward Rate: Forward rate is the 1 applicable to a dealing, which will happen at specified point of clip in future. Here, the value is fixed today but the colony is at some specified day of the month in the hereafter.

Future Rate: The one which applies to future bringing of the currency is known as future rate. Here, the contract is made today. However, the payment is done on some fixed day of the month in the hereafter with the rate-value on that twenty-four hours.

The floating Exchange Rate: The market determines a floating rate. A currency is deserving whatever purchasers are willing to pay for it. This is determined by Supply and Demand, which is in bend driven by foreign investing, import/export ratios, rising prices and a host of other economic factors. By and large, states with mature, stable economic markets will utilize a natation system. Virtually every major state uses this system, including US, Canada and Great Britain. Floating exchange rates are considered more efficient, because the market will automatically rectify the value to reflect rising prices and other economic forces.

Fixed Exchange Rate: A fixed exchange rate besides known as pegged, is one in which the value is set and unnaturally maintained by the authorities. The rate will be pegged to some other state ‘s dollar, normally the U.S. dollar. The determined value will non fluctuate from twenty-four hours to twenty-four hours.

Hybrid Exchange rates: A few exchange systems are 100 % natation, or 11 % pegged. Countries utilizing pegged rate can avoid market terrors and inflationary catastrophes by utilizing a natation nog. They peg their value to the US dollar, and that unit does non fluctuate from twenty-four hours to twenty-four hours. However, the authorities sporadically reviews their nog, and makes minor accommodation to maintain it in line with the true market value.

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2.0 IMPACT OF EXCHANGE RATE ON THE ECONOMY BOTH NATIONALLY AND INTERNATIONALLY WITH UNDERSTANDING OF FIXED EXCHANGE Rate FROM DEMAND AND SUPPLY PERSPECTIVE.

Fixed exchange rate has to make with a state or economic system under whichA the governmentA orA cardinal bankA fixes the official exchange rate to another state ‘s currency or the monetary value of valued goods like gold in order to guarantee a free flow of dealing between it and the other state ( s ) .A The intent of a fixed exchange rate system is to keep a state ‘s currency valueA within a really narrow band.A This is besides known as pegged exchange rate.

Investopedia Says ‘Fixed rates provide greater certainty for exporters and importers. This alsoA helps the authorities maintain low rising prices, which in the long tally should maintain involvement rates down and excite increased trade and investment’.A

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Fixed rates may supply a more stable environment for international investing and growing through turning away of uncertainness and associated costs ; train – inducement to avoid extra demand, rising prices, and B of P troubles ; less destabilizing guess. A really simple theory about this is the consideration of the sale of gold. If the monetary value of gold is pegged at the same monetary value for every state, it will guarantee that the demand and supply curve of the trade good is fixed and any alteration in demand will take to swift alteration in supply. No affair the measure demanded or supplied, the monetary value remains as agreed by the states involved as the exchange rate is pegged. The diagram below makes it more expressed.

Country A DD SS

P1 — — — — — — — — — — — — — –

P0 — — — — — — — — — — — — — — — — — — — — –

0 State B

From the above diagram, it is apparent that any alteration in the monetary value of the goods or a displacement in the supply of the trade good say, gold would intend same monetary value alteration as there exists a fixed exchange rate policy between the states.

On the other manus, drifting rates can absorb the menaces of domestic economic system dazes happening abroad and give domestic governments understanding in seeking joint ways to accomplish internal and external aims.

2.1 BENEFITS OF A FIXED Rate

Reduced hazard in international trade: This will assist purchasers and Sellerss of goods internationally to hold on a monetary value and non be capable to the hazard of ulterior alterations in the exchange rate before contracts are settled. The greater certainty should assist promote investings and enlargement.

Introduces subject in economic direction – As the load or hurting of accommodation to equilibrium is thrown onto the domestic economic system so authoritiess have a constitutional inducement non to follow inflationary policies. If they do, so unemployment and balance of payments jobs are certain to ensue as the economic system becomes uncompetitive.

Fixed rates cut down the impact of guesss: Guess flows can be really destabilizing for an economic system and the inducement to theorize is really little when the exchange rate is fixed.

Fixed exchange rate additions concern ties: The handiness of a fixed exchange rate allows for more concerns to be done by different states as this would cut down or extinguish fright of rising prices or deflation of currency as it may impact the states sing the impact of import and export.

2.2 DISADVANTAGES OF THE FIXED EXCHANGE Rate

No automatic balance of payments accommodation: A drifting exchange rate should cover with disequilibrium in the balance of payments without authorities intervention, and with no consequence on the domestic economic system. If there is a shortage so the currency falls doing you competitory once more. However, with a fixed rate, the job would hold to be solved by a decrease in the degree of aggregative demand. As demand drops people consume less imports and besides the monetary value degree falls doing you more competitory.

Large retentions of foreign exchange militias required – Fixed exchange rates require a authorities to keep big scale militias of foreign currency to keep the fixed rate – such militias have an chance cost.

Loss of freedom in your internal policy – The demands of the exchange rate can rule policy and this may non be best for the economic system at that point. Interest rates and other policies may be set for the value of the exchange rate instead than the more of import macro aims of rising prices and unemployment.

Fixed rates are inherently unstable – States within a fixed rate mechanism frequently follow different economic policies, the consequence of which tends to be differing rates of rising prices. What this means is that some states will hold low rising prices and be really competitory and others will hold high rising prices and non be really competitory. The uncompetitive states will be under terrible force per unit area continually and may, finally, have to devaluate. Speculators will cognize this and therefore creates farther force per unit area on that currency and, in bend, authorities.

( Mention: hypertext transfer protocol: //www.bized.co.uk/virtual/bank/economics/markets/foreign/further1.htm assessed on 28/12/10 )

3.0 Decision

Fixed exchange rate will let for a smooth concern in the international universe when it is allowed to work at its best sing the intercession of the authorities of each state that are involved. Besides to be noted is the fact that if an economic system is prone to perturbations from internal causes, there may be advantage in fixed rates as such that it would let for smooth trade within and internationally.

Therefore, fixed exchange rate would give a better opportunity for smooth, dependable and reliable market land with perfect market state of affairs which would guarantee a better and uninterrupted exchange of goods and trade goods.