Report On Exchange Rate Regime Or System 3
ANALYSIS OF DIFFERENT EXCHANGE RATE REGIMES WITH EFFECTS ON INTERNATIONAL TRADE
Analysis of Different Exchange Rate Regimes with effects on International trade
Exchange Rate Regime or System
It is an economic and financial system in which one country manages its exchange or foreign currency rate against other currencies as well as measurable standards such as gold and silver etc. it is imperative to remember that an exchange rate represents the price of any currency in terms of other foreign currencies.
Varieties of Exchange Rate Regimes
When different parties, investors and government authorities, trade or deal in Foreign Exchange (FOREX) market, it is quite imperative for all of them to be aware of variety of exchange rate regimes. From financial and technical perspectives, there are three exchange rate systems the characteristics of which are elaborated in succinct detail in the following manner:
Pegged Float Exchange Rate Regime
It is a currency management system where the currency rate of any country is fixed or linked around a specific band or value within which certain fluctuation in exchange rate is allowed to occur. Such a band or value is either periodically adjusted or fixed where the example Danish krone (DKK) is more prominent. This currency is pegged or linked to British Pound with a certain mechanism known as European Exchange Rate Mechanism (ERM) II. Here, the Danish krone (DKK) is allowed to fluctuate within a band or value of 15% against the British Pound.
When a certain country’s currency or exchange rate is pegged or linked to a certain currency and measurable standard, importers and exporters are able to accurately forecast their receipts and financial expectations from international trade. In other words, pegged or linked exchange rate regime simplifies international trade because it can temper interest rates and helps to curb inflation by following an already establishment benchmark or standard .
Central banking authorities of small nations or developing countries can increase their credibility in the global market by following a more established and disciplined nation. It can do so by fixing its exchange rate to such a country or measurable standard, as stated earlier. Benchmarking the foreign exchange or currency rate has an added advantage since much of the fluctuations and frequent volatility in the exchange rate and relative price level is reduced by keeping the foreign currency rate moving within a certain band.
Under pegged exchange rate regime, any fluctuation or irregularity in currency level outside the fixed band is difficult to re-balance since the forces of demand and supply are absent. Therefore, adjustment of trade deficit becomes impossible due to such a problem. In case of any market disequilibrium, pegged or linked exchange rate may witness excessive demand or irregular supply that certainly results in uncontrollable movements outside the fixed band. For dealing with such irregularities, central banks of smaller nations are forced to protect their foreign exchange rate or base currency only if they hold large stocks of other currencies as well as foreign reserves.
Fixed Exchange Rate Regime
Under this system, the value of a currency is fixed against another international currency of influence. Under fixed exchange rate regime, a currency’s value or rate may also be fixed against either any valuable measure (like gold and silver etc) or even to a basket/portfolio of different currencies. Fixed exchange rate system is aimed at fixing the exchange rate where government intervention is also encouraged to keep the rate constant against a certain measurable good or currency.
Furthermore, the fluctuation in currency rate in this exchange rate regime is discouraged. For maintaining fixed currency or exchange rate, central banks may enter the open market operations in the FOREX market. This is because the aim of maintaining fixed exchange rate regime is to ensure stability in capital movements and foreign trade. To achieve this purpose, central banks of countries that follow fixed exchange rate regime purchase their base currency in the FOREX market by selling foreign reserves when the local currency becomes weaker in the said market. Comparatively, when the base currency gets unusually stronger in the FOREX market, the concerned central banks intervene and purchase foreign reserves as well as sell their local currency.
Fixed exchange rate regime is sub-divided into two distinct categories. Firstly, when the base or domestic currency is linked or fixed against the value of another country’s exchange rate, this fixed foreign currency rate regime is known as “Pegging”. However, when the domestic currency is tied up to any other commodity (such as gold or silver etc), this regime is known as “Parity Value”. Examples of fixed currencies include the Danish krone, the Bermudian dollar and the Hong Kong dollar.
Advantages of Fixed Exchange Rates
The very first advantage of fixed exchange rate regime is that the currency is immune to frequent movements or fluctuations in unfavourable directions. Because of this, the income for export proceeds and cost of imported items tend to be free from any uncertainty that minimises risks associated with foreign investments and international trade.
The second advantage of following an exchange rate regime helps policymakers to keep the base currency free from speculative attacks since the currency rate is stabilised at a certain level. This causes foreign investors and businesses to become attracted to the commercial opportunities offered by countries following fixed exchange rate mechanism. In other words, the third biggest advantage of fixing an exchange rate against any other disciplined currency is stability in currency rate as well as attracting foreign investments.
Disadvantages if Fixed Exchange Rate Regime
As stated earlier, fixed exchange rates are free from speculative influences, but that is not the case at all times. In other words, though fixed currency rates are free from frequent fluctuations but this condition is absent in times of economic distress. If a country is facing Balance of Payments (BOP) deficit and speculators in FOREX market are able to identify that such a situation may prevail for a longer period.
It is likely that policymakers would depreciate or devalue the base currency to balance the economic situation. Speculators will start buying the home currency that forces the central bank of such country to keep reducing currency rate instead of stabilizing it at required level . The demand for devalued or depreciated currency rate increases. Later on, same speculators will buy the currency at declined or low exchange rate due to which they find it easy to make lucrative profits.
In addition to these disadvantages, if any poor country follows a fixed exchange rate regime, it would be obliged to maintain large levels of foreign Exchange (FOREX) Reserves. This is because in case of any periodic fluctuation, central bank may intervene accordingly to restore the equilibrium position in its base currency.
Another disadvantage of following a fixed exchange rate regime is that when a base currency is linked to the one belonging to another economy, the country following fixed regime loses its own monetary independence. For maintaining stability in its exchange rate, the country would be forced to follow contraction activity or expansionary monetary policy of a more established country.
Another problem with this kind of fixed currency management mechanism is that since two countries never follow the same economic policies specific to their own outlook, this regime does not reflect purchasing power parity and cost-price relation, in real terms, between two countries. This is because to reflect cost-price relationship, both the countries must follow a uniform floating or flexible exchange rate regime.
Effects of Pegged Float and Fixed Exchange Rate Regime
This section is discussed separately because pegged float and fixed exchange rate regimes tend to resemble each other. Therefore, their effects on international trade can never be different from one another. The only difference among these regimes is that the former mechanism is managed within a fixed band where the latter regime keeps the currency rate fixed no matter what the situation is.
It is important to remember that when any currency is pegged or fixed in relation to other currencies, its home economy is forced to follow economic policies of a more established and disciplined economy. The level of interest rates as well as monetary and fiscal policies must be matched when following any of the pegging or fixed exchange rate regimes.
When countries follow pegging or fixed currency rate mechanisms, the depreciation or devaluation of both the countries’ currencies tend to reduce the value of the base (domestic) currency. In contrast, if both of the economies appreciate their currencies by intervening in the FOREX market, the value of domestic currency increases in the marketplace.
Floating Exchange Rate Regime
This is an exchange rate regime where the base currency is allowed to fluctuate freely in relation to others subject to market forces of demand and supply. A fluctuating, flexible or floating exchange rate regime is a type of currency management mechanism wherein a currency's rate is encouraged to freely fluctuate as per the dynamics of foreign exchange (FOREX) market. Just like fixed exchange rate regime, this mechanism involves central bank intervention for minimising excessive volatility in the base currency using a “managed float”. Comparatively, the difference between fixed and floating exchange rate regime is that there exists no official government intervention in the latter currency management mechanism.
The exchange rate of any currency is determined by the forces of demand and supply through at a time interaction of banks, investors, large organisations and speculators etc who trade foreign currencies. In the worldwide market, floating exchange rate regime is followed strictly by many disciplined and established currencies such as the British pound (GBP), the Japanese yen (JPY), the European Union euro (EUR) and the US dollar (USD). The exchange rate of these currencies is determined by increasing supply and demand forces for spot rates. In floating or flexible exchange rate regime, currency rates are determined depending upon different market dynamics due to which this currency maintenance system is also known as “dirty floating”.
Because central banks can intervene to appreciate or depreciate their respective base currency by trading foreign reserves, this exchange rate regime can be thought of as Managed Floating Exchange Rates Mechanism. Under fixed exchange rate regime, central banks try to restrict fluctuations in the exchange rate of their base/domestic currency by intervening in the FOREX market. This is done in an attempt to keep the currency value close to the desired level.
Advantages of Floating Exchange Rate Mechanism
The very first advantage of this regime is that floating exchange rates are never dependent on maintenance of any global standard or international benchmark. Current account deficits are accompanied by depreciation in base currency as well as appreciation of foreign exchange rates and vice versa. In the same manner, since flexible or floating exchange rates are determined by the strict forces of market demand and supply among different participants, there is no need for every country’s central banks to intervene in the market trade frequently for maintenance of currency rate at a certain level. Secondly, while portfolio-based cash flow stream is moving in and out of an economy, it becomes cumbersome to maintain Purchasing Power Parity (PPP) in a fixed exchange rate regime which is vital for promoting market efficiency since all parties are able to profit from increase in demand and supply.
Disadvantages of Floating Exchange Rates
Flexible are highly volatile due to which the possibility and certainty of losing on any transaction is really very high since exchange rates in this regime are certainly uncontrollable. In other words, participants in the trade of currencies following floating exchange rate regime face increased vulnerability to market trade. This consumes most of their time, resources and energies to be able to predict market movements in currency rates.
Economic problems, such as increasing unemployment and higher inflationary pressures, are greatly magnified in floating exchange rate regimes . For example, due to higher inflation prevailing in any country, currency depreciation will further increase the price level and reduce purchasing power of local citizens and other economic agents. This is so because the competitiveness and demand for local goods increases in the domestic economy. However, the demand for the same goods in international market would decline while imports become more expensive than normal.
Effects of Floating or Flexible Exchange Rates on International Trade
In this section, the floating exchange rate mechanism is explained by considering Australian and Japanese economies that follow floating currency rate mechanisms. For both of these economies, floating exchange rate mechanism acts as a shock absorber to insulate or restore any disturbances in overseas business or international trade . This is because the relationship between the foreign exchange market and our international transactions runs in both directions. For instance, suppose that the Japanese economy is facing a recessionary pressure. Because of this, the demand for products imported from Australia in Japan declines sharply.
Resultantly, due to decline in Australian products in Japan, the former country will witness a slowdown in its economic activities. To bring about an expansion its exports to a valued customer, Japan, Australian policymakers may decide to devalue or depreciate Australian Dollar (AUD) against Japanese yen (JPY). Apart from exports, such flexibility in exchange rate between Australian Dollar (AUD) and Japanese yen (JPY) will increase net capital inflow in Australian economy for cushioning it against recession. The cost of imports from Australia would decline for the Japanese economy. Not only Australians would be able to keep Japan as its value consumer of its goods but Japanese economy can also reduce its cost of importing products by following floating or flexible exchange rate mechanism. In all, floating exchange rates help in reducing the shocks from economic instability in the domestic and international market.
Recommendations for Improving International Trade with Exchange rate Regimes
These days, it must be realized that with the rise of globalisation has become central all over the world instead of being specific to a certain country. Problems and negative impacts in one country can easily be found having influences in other countries. The greatest example is of financial crisis of 2008 which spread all over the world though such a disaster had its origin in the United States.
Apart from this, the U.S. Government has extended it influence so much that the U.S. Dollar has become a currency of international standard. The Government of United States always take actions to keeps its currency strong relative to other economies. There are many countries (such as Pakistan and Caricom countries etc) that have fixed their currencies to exchange rate of the U.S. Dollar. In such a pursuit, the exports of these countries have become expensive for importers in other economies. Therefore, the cost of imports from non-US Dollar economies becomes high that also raises the cost of living of countries that have fixed their currencies to the U.S. Dollar.
Therefore, after carefully analysing different exchange rate regimes, it is recommended for countries to refrain from following a certain country in fixing an exchange rate. Apart from advantages, every exchange rate regime has its own disadvantages. Therefore, developing and poor countries should set their exchange rates relative to only those countries with whom their international trade activity is increasing. This is because other currencies (such as the British Sterling, the European Union Euro, the Japanese Yen and the Chinese Yuan have also a growing importance in the global marketplace .
Such a policy action is recommended because if countries link or fix their exchange rates to the US Dollar, they would be forced all the time to follow US policies and try to match their monetary activities to the ones pursued in the United States. This way, countries may be linking their fortune to the United States economy alone. Any policy working well for the United States may not work for another economy. Because the pursuit of exchange rate regime is complex, this is the only recommendation which could be made, therefore, this policy action should be accompanied an extensive research by every country. However, it s also recommended that exchange rate should be allowed to fluctuate freely within a certain limit due to forces of demand and supply for motivating different parties to involve in its trade activity. In a completely fixed exchange rate regime, importers and exporters cannot benefit even though they can accurately forecast their costs and benefits.
Bosworth, B.P., Furman, J., Stiglitz, J.E. & Radelet, S., 1998. Economic Crises: Evidence and Insights from East Asia. Brookings Papers on Economic Activity, (2), pp.1-114.
Corsetti, G., Pesenti, P. & Roubini, N., 1998. What Caused the Asian Currency and Financial Crisis? Part II: The Policy Debate. Japan and the World Economy Journal (Elsevier), 11(3), pp.305-73.
Eichengreen, B. & Razo-Garcia, R., 2006. The international monetary system in the last and next 20 years. Economic Policy Panel, 21(47), pp.393-442.
Levy-Yeyati, E. & Sturzenegger, F., 2005. Classifying exchange rate regimes: Deeds vs. words. European Economic Review, 49(6), pp.1603-1635.
Sanders, R., 2015. Fixed or floating exchange rates: Which would serve the Caribbean better? [Online] Available at: http://www.jamaicaobserver.com/columns/Fixed-or-floating-exchange-rates--Which-would-serve-the-Caribbean-better-_18901860 [Accessed 06 January 2016].