The exchange rate was created in order to promote exchange stability and to prevent competitive exchange depreciation. Initially, the IMF had the role in guarding the system of fixed exchange rates. In the early 1970s, when the IMF Articles of Agreement was revised, each member country was considerable given the freedom in choosing the preferred exchange rate, thus IMF assumed the responsibility to work out surveillance over the operation of the IMF system and the members roles under Article IV, which constituted those on exchange rate rules.
Since the article gave out the freedom, the role of the IMF in exchange rate surveillance was diminished drastically and could not perform other obligations (Fischer, 2008). These Articles gave member state to choose the most preferred exchange rate of their choice that limited the scope of the IMF on the regime choice. Due to the resulting lack of professional agreement and the margin of mistake inherent in popular analytical tools, specialists always hold divergent and different views on whether any change in exchange rate regime or rate of exchange level is needed for different states.
History of the exchange rate regimeThe exchange rate regimes are traced back in the early 1990s. This regime proposes that all states should be stirring to the corner solutions, where they are opting that states should have either, full flexibility, or inflexible institutional commitments to fixed exchange rates.
Exchange rate regime emerged when the world suffered financial crises in the late 1990s; experts usually believed that these crises resulted from weak economic factors, for instance, deteriorating foreign reserve, the increment in foreign debts, current account deficits, fiscal deficit and many others. Apparently, a current account deficit is the most crucial factor because, it increases foreign debt, and it reduces foreign reserves and deteriorates confidence in the exchange rate, especially for the domestic currency. Most countries that were affected had faced rising current account deficits, thus, this regime came with an aim of controlling all these crises among the world countries.
Advantages of Fixed Exchange Rates
Fixed Exchange Rates has the following advantages:
1. Promotes International Trade
It ensures there is certainty about the foreign payments, and this creates confidence to the importers and exporters when this is assured the investors have no worries on the fluctuations of the prices and the currency depreciation (Benassy, 2010). This promotes international trade.
2. Necessary for Small Nations
Fixed exchange rates essential for the smaller nations, especially when economies of foreign trade play a significant role. When exchange rates Fluctuate in these nations, it is likely to cause an adverse effect on their economic growth.
3. Promotes International Investment
It promotes international investments. When the exchange rates are changing from time to time, the lenders and other investors will not be at a position of land for long-term investments.
4. Removes Speculation
Fixed exchange rates help in eliminating the speculative activities in the global transactions. This ensures that there is no possibility of fright flight of capital from one state to another so long as the system of fixed exchange rate applies.
6. Necessary for Developing Countries
It is necessary and appropriate for the developing nations especially for conducting out planned development efforts. When these rates Fluctuate, they are likely to disturb the smooth processing of the economic development and thus likely to restrict the inflow of external capital.
7. Suitable for Currency Area
A stable exchange rate system is the most appropriate to a world of currency areas, for instance, the sterling area. When the exchange rates fluctuate in the common currency area, may lead to disturbance of the whole area (Tavlas, 2007). For example, countries like England whose currency dominates.
8. Economic Stabilization
Fixed foreign exchange rate tends to stabilize the internal economic and controls unjustified variations in the prices within the countrys economy. In the case where the system is flexible, it means the liquidity preference is high, this may tend to Increase price and hoarding activities within the state.
9. Not Permanently Fixed
This system is appropriate since it only fluctuates under the fixed circumstances where the exchange rate is not permanently frozen. Rather it is changed at the appropriate time and circumstance to correct the fundamental disequilibrium factors in the balance of payments.
Disadvantages of Fixed Exchange Rates
This system has been criticized for having some disadvantages as shown:
1. Outmoded System
This system only worked successfully under the favorable factors of gold standard during the 19th century. This is when the states allowed the balance of payments to inspire the domestic economic policy; when there was harmonization of monetary rules of the trading states; when the central banks aimed at controlling the external currency value in their respective states; and when the prices were flexible. Since all these factors are absent nowadays, the smooth running of this system is not possible.
2. Discourage Foreign Investment
Since the system is not permanently fixed or rigid that it is changed under certain circumstances to correct disequilibrium conditions, this may hinder and discourages long-term foreign investment.
3. Monetary Dependence
A country may be deprived its monetary independence when operating under the exchange rates that is fixed. Therefore, this will require a country to follow a policy of monetary expansion or contraction so that to maintain stability in this rate of exchange.
4. Cost-Price Relationship not reflected
Where the system is fixed exchange rate, the true cost-price relationship is not reflected among the currencies of the states. Since no two countries can follow under the same economic policies, the cost-price relationship among these states might go on changing. Therefore, for the cost-price relationship between the countries to be reflected, the exchange rate must be flexible.
5. Not a Genuinely Fixed System
The system does not provide the expectation of enduringly stable rates as established in the gold standard system; it does not also provide the continuous and subtle adjustment of an easily fluctuating exchange rate.
6. Difficulties of IMF System
According to the IMF, the pegged exchange rates, involves many difficulties that includes; difficulties when changing the external value of the money, when deciding what will be the suitable criteria for evaluation; and how much devaluing factors is needed to reinvent equilibrium in the balance of payments of the state of devaluation.
What Is the Difference Between a Fixed and a Floating Exchange Rate?
A fixed exchange rate signifies a nominal exchange rate that is set resolutely by the monetary specialist with respect to external currency while a floating exchange rate can be determined with respect to an external exchange market that depends on demand and supply, and this normally fluctuates repetitively.
A fixed exchange rate decreases the business costs implied by the system rate uncertainty, this might depress international investment, and it offers a trustworthy anchor for low-inflationary financial policy. In contrast, the autonomous financial policy is missing in this regime, because the central bank has to intervene in the external exchange market in order to control the exchange rate at the formally set level. The autonomous financial policy is, therefore, a significance benefit of the floating exchange rate.
A pegged rate is one that the government sets and control at the certified exchange rate. On the other hand, floating rate is controlled by the private market via supply and demand, and thus called "self-correcting," this means that any changes in supply and demand will be adjusted in the market
Reasons That Made Hong Kong to Opt for the Fixed Exchange Rate
Liability dollarization and original sin
The first reason why the Hong Kong opted for the fixed exchange rate was the issue of liability dollarization, which is a condition where liabilities are denominated in external currencies whereas assets are in the local currencies. Consequently, liability dollarization can also be referred to as currency (Reinhart, 2008). Under this currency disparity, an unanticipated depreciation of local money would deteriorate corporation's balance sheets, and cause shrink in an asset that is comparative to foreign money debts that would hover the stability of the monetary system in the local state. In nations with noteworthy currency disparities, the balance sheet result is quite considerable, thus, Hong Kong could not ignore this, as the high exchange rate instability can prove to a bit costly.
Another reason was the issues of "original sin" This is a situation that "most emerging nations are not able to borrow overseas in their local currency". Original sin exists in most developing countries, with the high inflation rate and economies with high currency depreciation. This market leads to widespread liability in dollarization phenomenon. This raises the concern to take care of the imperfection markets hence the measures were to be taken immediately by use of the fixed exchange rate.
The cases of floating rate mainly focus on currency depreciation. However, when following the money disparity channel and balance sheet impacts, it associates with an output cost, which is as a result of depreciation of local currency, generally, uncertainty in floating exchange rate would decrease investment, and thus creating additional output costs, thus making them prefer fixed exchange rate that attempts to avoid all those costs.
Actually, instability affects financial growth not only via its direct effect on dropping asset, but it also hampers productivity growth by inflicting negative effect on the efficiency of investment allocation. For instance, some experts find a strong indication of how comparative price instability.
Concern for credibility and inflation
Another main reason that made them prefer this system was the issue of credibility and the inflation effect that arises from the combination of lack of credibility and the inflation. This is also inspired by the fact that trend in developing markets exists to pair floating with the explicit inflation target. The main concern is that exchange rate volatility could lead to inflation instability, which could hamper and reduce the credibility of financial policymakers for inflation targeting. Therefore made them prefer the fixed system, which is stable and cannot reduce the credibility at large.
Fear of appreciation
This state feared appreciation that is termed as an intervention in foreign exchange marketplace to prevent unexpected or large depreciation. However, in other cases, this intervention has been used in avoiding quick appreciations of local currency. One distinctive instance is the debate happened on undervalued Chinese currency.
The most know argument against appreciation was that against US dollar which came from a neo-mercantilist view. A depreciated floating exchange rate could rouse the export businesses, and provide shield for local industries since foreign goods were more expensive in terms of local currency, thus they opted this to ensure they are not exploited by foreign investors
From the scholars and policy makers who examined if this "fear of appreciation" could affect the performance growth positively in develo...
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