Among the most critical concerns of monetary policy is determining whether the government should intervene in establishing the exchange rates, taking into consideration the aspect of alterations in the exchange rates indicate a critical communication medium of the net impacts resulting from the monetary policy. While taking into account unsuccessful fixed exchange rate systems and the development of financial markets, the return to such a system is not foreseeable in the future. Meanwhile, it is apparent that in order to adapt to evolving economic developments in the exchange rate systems, governments are required to make a choice between floating exchange rates and fixed exchange rates. In light of these, previous systems such as the European Monetary System (EMS) and the Bretton Woods systems, which relied on pegged exchange rates are not viable given their potential to speculative abuse.
Countries have attempted to use various exchange rate systems in an aspiration to arrive at the optimal economic and trade balance. Significantly, countries preferred using fixed exchange rate systems in their monetary policies; however, the pertinent question is the extent, to which countries can influence the exchange rate needs to be determined and reflect on the respective economic and trade environment. Exchange rates have been characterized as critical indicators of the impacts of a country’s monetary policy.
Fixed Exchange Rate System
The critical aspects of a fixed exchange rate system are premised in the fact that the exchange rate is determined by the government, where every foreign currency depicting an exchange rate that characteristically differs from the commercial exchange rate, which is determined in the financial markets (Straumann 2010, p. 171-174). The advocacy for fixed exchange rates is premised as a dismissal of flexible rates, which applies to other adjustable exchange rates. The uncertainty resulting from alterations in the exchange rate fluctuations is perceived as a tax on investment and trade on goods sector. The use of derivative instruments cannot be relied on in hedging risks associated with exchange rates without adequate information on the extent of exposure to foreign currency (Straumann 2010, p. 171-174). Fluctuations in exchange rates have been observed to influence the domestic rates and foreign rates through value and volumes of expected future trade. It has been observed that the uncertainty associated with exchange rates is quantified through the determination of the elasticity of the exchange rate in the short term .This is a result of the difficulty in predicting the rates in the long term and creating an accurate measure of the variables.
Fixed exchange rates fluctuations lead to protective initiatives, which can lead to the prevention of realizing the trade gains. In this exchange rate system, a country’s central bank has a critical function in intervening in the foreign exchange market to influence the market exchange rate and steer it to equate to the official rate. In the past, the extent of the official rate was established differently, where currencies were converted to gold. The fixed exchange rate system was initiated through the International Monetary System (IMS) from Bretton Woods, which was effective until 1971(Mussa 1986, p. 134).
Floating Exchange Rate
The defining aspect of floating (flexible) exchange rate system is premised in the fact that extent of the exchange rate is determined by the forces of supply and demand on the financial exchange market, where the government has no direct or indirect influence in the matter. Within a floating exchange rate system, this aspect determines that the eventual adjustment of a monetary deficiency executed in the usage of a different approach from that used by the fixed exchange rate. This is achieved through gradual and continuous differentiation in the pricing of foreign currency.
Therefore, the exchange rate’s flexibility has the effect of turning the economic variables to critical methods of regulating the economic scales. This functions as a buffer; which characteristically attenuates or interrupts the process, where currency imbalances are conveyed from one country to another. Therefore, in the event that within a currency system premised on fixed exchange rates, where the resulting imbalances in the currency are handed over from one country to another; increase in monetary volume of a given country will not result to the effect of spreading and propagation (Straumann 2010, p. 171-174). However, this will result in the exchange rate acting as a buffer, which allows the asymmetrical shocks to be absorbed. On the other hand, the floating exchange rate assumes the developer function, which integrates the information availed in the evolution and extent of exchange rate.
One of the significant arguments advocating for the fixed exchange rate systems is that a stable exchange rate has the effect of stimulating international trade. Therefore, where the exchange rate fluctuations controlled, a dynamic international trade is realized. Meanwhile, stable exchange rates lead to an economic balance, where changes motivated by the economic policy measures will not have significant impacts on the economic agents embedded in the fixed exchange rate systems, the financial and monetary crises may pass unnoticed. Fixed exchange rate systems have the tendency of preventing speculative trading activities.
A fixed exchange rate system has significant influence and impact on a country’s monetary policy. Fixed exchange rate has the tendency to neutralize significant monetary shocks, which include those that result from mistakes committed by the central banks. Therefore, in the event of a shift in the supply or demand, money will be imported or exported automatically. Thus, the resulting monetary shock is prevented from affecting the country’s real economic balance (Klein & Shambaug 2010, p. 172). Therefore, this is justified but can only be observed in instances where there is perfect mobility of capital. Where money supply is in excess, a resulting loss of retained reserves and outflow of capital will be observed, which minimizes money supply subsequently eliminating the excess supply of money (Devereux & Engel 1998, p. 38-39). The same case applies where there is an excess demand for money, which leads to capital inflow where reserves are increased; thus raising the supply of money resulting to the satisfaction of the excess demand for money.
Therefore, no other effects are observed on the economy. However, the argument has a symmetrical perspective, hence, has a negative side. For instance, If country A’s central bank is less competent than country B’s central bank, then country B should fix their currency to that of A, hence, export the shortcomings of country B’s central bank. However, if the country being pegged has deficiencies in the competency of their central bank, the pegging country may inherit those shortcomings leading to a compromised exchange rate (Rose 2011, p. 163-165). This aspect exposes the error in the argument. Therefore, its universal application cannot stand, as a factor to global pegging only in the event of all central banks being equally incompetent where their shortcomings are uncorrelated. Hence, every country will have a stake in the consequences of the mistakes of others.
The pegging of exchange rate can be utilized in achieving large, reduction in inflation, where there are indications of chronic suffering from hyperinflation in a country. This observation integrates two factors. On the one hand, pegging an exchange rate in conjunction with arbitrage of goods market has the tendency of stabilizing the price of traded commodities. Inherently, it takes advantage of hyperinflation leading to the extensive indexation of local prices premised on the exchange rate (Levy-Yeyati, Sturzenegger & Reggio 2009, p. 5-7). However, inflation characteristically depreciates the local currency leading to further increments in local prices. Fixing the exchange rate aids in stopping this process as soon as possible. On the other hand, the reliance on a pegged exchange rate is an implied reliance to fiscal and monetary stability; in the absence of this, affixed rate cannot be sustained. Thus, the pegging of exchange rate is a means, in which credibility is attained. This approach has been effective in given countries such as Brazil, Bolivia, Argentina and Poland (Calvo & Mishkin 2003, p. 100-101).
However, the application of these methods failed to work in some of the countries, and inflation there persisted. It was observed that there was a quick stabilization of traded goods prices, while a rise in prices of non-traded goods was observed. These rose gradually than before, but substantially to culminate to a significant appreciation of the actual exchange rate while the current account balance deteriorated (Chinn & Wei 2009, p. 3-19). Therefore, when this approach is used, it is critical to devalue the local currency.
In light of this, these measures should integrate the adoption of strategic contingency plans, where the flexibility of exchange rates is introduced before substantial appreciation of the actual exchange rates. Meanwhile, the monetary independence represents both a negative and a positive characteristic for nations, which opt for fixed exchange rates in mitigating inflation and those, which opt to have significant control over their economies. Consequently, it emerges that the degree of success, both for the floating and fixed exchange rate regime systems is dependent on prudent fiscal and monetary policies.
The choice of fixed rates makes it possible for countries to implement a more judicious monetary policy; while opting for floating exchange rates indicates an achievement for the countries, which have a judicious monetary policy in place. Therefore, when there are adequate policies in place, a floating exchange rate system will function optimally. In light of this, fixed exchange rate systems have been observed as the optimal choice, where a country is undergoing recovery at a significant rate towards more effective and efficient monetary policy.
While considering the development of financial markets and the failed fixed exchange rate systems, such as the Bretton Woods system, it is practically impossible for countries to revert to these systems, since they are obsolete and unreliable given the developments in the current financial and monetary sectors in the world. A significant percentage of the countries in the world have opted to use a blended exchange rate system; where the criteria for establishing the exchange rates is in theory free, but the sporadic intervention of the relevant authorities is critical in rectifying the fluctuations in currency rates. There is a significant merit in the global countries reaching a monetary agreement for unified intervention of the currency market. However, each country has defined issues that govern their economies and are dissimilar to those of other countries.
Costs and benefits
A floating exchange rate creates a market where prices are determined by demand and supply; therefore, an increase in a given commodity’s price may be construed as an indicator of the respective country’s demand curve, thus boosting economic growth in the short term. Meanwhile the reduction of total demand, mitigates an inflationary trend depicted by the dollar. Therefore, the flexibility of the floating exchange rate enables the economy to be steered in the appropriate direction. Additionally since automatic adjustment is provided for by floating exchange rates, this creates a buffer effect to the local economy from changes in international demand and supply. Hence, it acts as an automated internal adjustment.
However, the sustenance of a floating exchange rate does not need the support of the fiscal and monetary policy. A drawback to monetary and fiscal autonomy is that a state may pursue detrimental policies which may cause significant drawbacks to the economic and trade atmosphere in the country (CRS 2004, p. 3). Meanwhile the uncertainty and volatility of the floating exchange rate may discourage international and investment and trade from achieving any significant growth.
On the other hand, a fixed exchange rate has the benefit of promoting international investment and trade through the elimination of the exchange rate risk. However, a fixed exchange rate has drawback in that it affords the state with a limited scope in using fiscal and monetary policies in the promotion of local economic stability.
Businesses are premised on strategic planning,; therefore, where business financing requires the use of a loan. The choice of the applicable interest rate on such a loan depends significantly on the costs on the loan. For instance, the application of a floating rate in servicing a business loan which is converted to a fixed rate; therefore, taking advantage of foreseeable decrease in exchange rates, thus creating an opportunity for locking in at significantly lower prices. In a business environment, it has been observed that floating rates incur significantly lower payments in contrast to fixed exchange rates (Biz2Credit 2012). This aspect of the interest rates creates room for additional capital for business and other companies start up which has significantly higher breakeven periods and initial costs.
Floating interest rates are optimal for business that require significant initial capital outlay, however, business which require more support in capital expansions and those with a lower initial capital outlay may opt for a fixed exchange rate. An optimal business environment is depended on the forces of demand and supply; therefore, a market whose interest rates are constrained is not viable for an international business.
Meanwhile the selection of financing for a business should take into consideration the going concern aspect of the business and the owner’s intentions towards the business in the future. Therefore, the method of financing is premised on the repayment conditions and a subsequent penalty in the event of default. It is critical for any business to succeed to have the market forces be left to operate freely without government interference.
In light of this, markets, which are characterized by floating exchange rates, are more preferable for an international business. These enable the prices to be determined by the market forces. However, in markets where fixed exchange rates are applicable, the market prices are fixed and may not reflect the true prices as determined by the forces of demand and supply.
The rigidity of fixed exchange rates creates a significantly constrained monetary policy, while the economic development is strained by these aspects. It is critical that while the control of the foreign exchange rate is the responsibility of the government, more so of the central bank, it is essential that a free market is established. This will create a balance in the monetary and fiscal policies, hence a progressive national economic policy. Meanwhile, floating exchange rates systems cannot be without regulation; where significant fluctuations in pricing are corrected by an autonomous monetary agency through elaborate monetary and fiscal policies.