QUESTION ONE PROS AND CONS OF FIXED EXCHANGE RATE SYSTEMS Arguments in Favor of a Fixed Rate

Reduced risk in international trade - By maintaining a fixed rate, buyers and sellers of goods internationally can agree a price and not be subject to the risk of later changes in the exchange rate before contracts are settled. The greater certainty should help encourage investment. Introduces discipline in economic management - As the burden or pain of adjustment to equilibrium is thrown onto the domestic economy then governments have a built-in incentive not to follow inflationary policies. If they do, then unemployment and balance of payments problems are certain to result as the economy becomes uncompetitive. Fixed rates should eliminate destabilising speculation Speculation flows can be very destabilising for an economy and the incentive to speculate is very small when the exchange rate is fixed. Disadvantages of the Fixed Exchange Rate No automatic balance of payments adjustment - A floating exchange rate should deal with a disequilibrium in the balance of payments without government interference, and with no effect on the domestic economy. If there is a deficit then the currency falls making you competitive again. However, with a fixed rate, the problem would have to be solved by a reduction in the level of aggregate demand. As demand drops people consume less imports and also the price level falls making you more competitive. Large holdings of foreign exchange reserves required Fixed exchange rates require a government to hold large scale reserves of foreign currency to maintain the fixed rate - such reserves have an opportunity cost. Loss of freedom in your internal policy - The needs of the exchange rate can dominate policy and this may not be best for the economy at that point. Interest rates and other policies may

be set for the value of the exchange rate rather than the more important macro objectives of inflation and unemployment.

Fixed rates are inherently unstable - Countries within a fixed rate mechanism often follow different economic policies, the result of which tends to be differing rates of inflation. What this means is that some countries will have low inflation and be very competitive and others will have high inflation and not be very competitive. The uncompetitive countries will be under severe pressure continually and may, ultimately, have to devalue. Speculators will know this and thus creates further pressure on that currency and, in turn, government.