Should a country adopt fixed or flexible exchange rate system?

Exchange rates are in the heart of macroeconomics because they are the basis for cross-border trade. With an exception of the countries in the Euro Zone, other countries trade in their own currencies. To do so, a form of exchange rate for the currencies has to be adopted. A flexible exchange rate system leaves the rate to be determined by the market forces for that currency supply and demand. A fixed exchange rate system requires governing authorities to intervene to maintain a particular rate. Throughout the essay, an argument supported with relevant economic theory will be adopted and finally, a conclusion will be reached as to whether a country should adopt a fixed or flexible exchange rate system.

Beginning with a flexible exchange rate system how does it work? In a flexible exchange rate system, the value of the currency is left to the mercy of the market forces, and the government does not intervene to influence the exchange rate. Lets use the Malaysian ringgit (MYR) as an example to illustrate. The demand for ringgits will come from foreigners needing to purchase Malaysian goods and services but do not currently have ringgits. This would include US importers of Malaysian timber, Chinese students wanting to study in Malaysia, Germans residents wanting to buy assets in Malaysia etc. - the total demand being from all these countries plus the rest of the world. The demand curve can be plotted with a vertical axis showing the price of the ringgit (in terms of the other currencies) and the horizontal axis showing the quantity demanded. The demand curve for ringgits is downward slopping because when the price of the ringgit is high, the foreigners will have to forgo more of their currency to purchase one ringgit for any transaction. Goods, services and assets in

Malaysia will seem relatively expensive and people will switch to cheaper alternatives. If the price of the ringgit is low, the opposite happens. Foreigners will want to import from Malaysia because they can have more of the ringgit with less of their currency, and can therefore purchase more of Malaysian goods and services. The supply of ringgits is essentially the exact opposite of demand. Malaysian students going for studies in France will need to make payment in francs or euros, Proton purchasing custom engines from Mitsubishi in Japan will have to pay in yens, the Malaysian government wanting to increase its reserve of US$ will have to buy dollars. In all these transactions, the ringgit will be sold so as to purchase the required currency euro, yen or dollar. When the ringgit is sold, supply of ringgits is created in the foreign exchange market. The equilibrium of supply of and demand for ringgits will the price at which the ringgit trades for any price above the equilibrium will cause excess supply and cause the ringgit to depreciate and any price below will cause excess demand and an appreciation of the ringgit. Therefore, in a flexible exchange rate system there will fluctuations in the rate according to the market forces.

Why would a country adopt a flexible exchange rate system? There are four main advantages of this system. According to (Frankel, 2003), the leading advantage of exchange rate flexibility is that it allows the country to pursue and independent monetary policy. The first advantage is monetary policy autonomy. The central banks will be able to control inflation and unemployment and other macroeconomics variables without having to worry about the exchange rate. Using the IS-LM-BP model to illustrate: the assumption is an economy with intermediate capital mobility and a fixed exchange rate system. An expansionary monetary policy will increase the money supply MS. This will cause a leftward shift in the LM curve because =

 . This shift will result to a decline in the interest rates, causing capital outflows and a depreciation in the exchange rate. Since the rate is fixed, the government will have to sell foreign reserves to maintain the peg. This reduces H and the LM curve will shift back to its original position at the initial interest rate and income level. In other words, the relative prices of imports and exports cannot change; hence domestic output and employment must fall (Rogoff and Obstfeld, 1995). The monetary policy tools cannot be used simultaneously to maintain the exchange rate and deal with domestic economic variables. A very good example of an economy that enjoys such independence in the monetary system is the UK, where the Bank of England sets the monetary policy and the forex market determines exchange rate.

The second advantage of having a floating exchange rate system is the reduced requirement by the countrys central bank to have massive reserves of foreign currency. Since the government does not set a fixed rate, there is less need to hold foreign currency reserves (and gold) that would be used to adjust the exchange rate when it begins to fall below its pegged level. The 1994 economic crisis in Mexico is a vivid example. In February 1994, the Mexican foreign reserves were at a peak of almost 30 billion US$, internal political instability in Mexico caused investors to lose confidence in the economy, and speculation begun. Mexico defended its exchange rate buy buying the excess peso and selling the US$. By December 1994, the reserves had depleted to almost 4 billion US$ (around 85%) and the Mexican government had no option but to devalue the peso by 15%.

The third advantage is that theoretically, a floating exchange rate system should keep the current account balanced. Using the ringgit again to illustrate here, if

there is a permanent fall in demand for timber exports from Malaysia, the current account will be in a deficit. This follows that the demand for ringgits in the forex market will also fall. A fall in demand will cause ringgit to depreciate. As the ringgit depreciates, the relative prices of exports will go down, and imports will become more expensive. This will lead to more exports and less imports which at least in theory will eliminate the current account deficit. However, the deficit will be eliminated only if the Marshall-Lerner condition is met - the total elasticity of demand for imports and exports should be greater than one. If it is less, then it may cause the current account balance to worsen. In the long run however, the elasticity tends to increase and should fix the deficit.

The fourth advantage is that a flexible exchange rate reduces the impact of mass speculation on the currency. In a flexible exchange rate regime, the prevailing rate is the equilibrium of supply and demand for the currency in the forex market. Therefore, any over and undervaluation are likely to be minimal and the market forces will quickly clear such conditions. This is in contrast to a fixed regime, where there could be an obvious overvaluation of a currency that it backed up by the government this will face attacks from international speculators to a point where the currency will have to float or devalue like the Mexican peso example above.

Lets focus our attention on fixed exchange rates. How do they work? In such a regime the value of currency is fixed or pegged to the value one currency such as the US$, other major currency like the pound sterling or yens, a basket of currencies or even gold (before 1971, the US$ was pegged to the value of gold). The authorities fix the exchange rate not at a specific value, rather a narrow band. Using the Chinese

Yuan Renminbi (CYN) as an illustration the Chinese government may have fixed the yuan exchange rate between 6.4 and 6.6 per US$. If there is an increase in demand for yuan which causes the rate to rise above 6.6, the authorities will have to use sell yuans and purchase dollars to keep the rate within the band. However, if the demand for yuans fall and cause the rate to fall below 6.4, the authorities will have to sell dollars and purchase yuans. For this, they must have had a large US$ reserve, otherwise they will be forced to pull down the whole exchange rate band (devalue the yuan) or take actions to move the demand and supply curves like raise interest rates which could increase the capital inflows and increase the demand to the level that will raise the exchange rate to 6.4.

The first advantage of a fixed exchange rate regime is that it reduces uncertainty in the economy. In (Frankel, 2003) it is stated higher exchange rate variability would create uncertainty; this risk would in turn discourage international trade and investment. Businesses that want to invest in and out of the country should be able to plan ahead knowing the forecasted costs and prices will not change as a result in exchange rate fluctuation i.e. they are confident because the exchange rate risk will be eliminated. This is good for the economy as certainty attracts investors. (Kennen, 2000) states that exchange rate fluctuations by a flexible regime act as a tax on trade and a tax on investment by increasing risk for traders and investors.

The second advantage of fixed exchange rates is that the economy will have more control over inflationary pressures caused by fluctuations in exchange rates. A stable exchange rate will allow producers to set wages and prices accordingly. To illustrate this, lets consider a country whose production is highly dependent on

imported raw materials. Depreciation in the exchange rate would make imports expensive, which in turn would cause inflationary pressures; businesses would be forced to push prices up. The end result of a peg is that a country will be able to attain a lower level of inflation for any given level of output (Frankel, 2003). Although its unlikely that inflation will stop immediately after the peg, at least the domestic prices of traded goods will be stabilized. China is a good example; the average inflation rate from the year 1994 to 2010 is 4.25% making it very competitive worldwide.

The third advantage of this regime is that it reduces the costs of currency hedging. Hedging involves a number of strategies aimed to reduce the exchange rate risk exposure. It included gaining a right to purchase or sell foreign currency at a future date using a rate that was set in the past. It is equivalent to obtaining insurance in case of an unexpected appreciation or depreciation in the exchange rate that would affect adversely the cost of the transaction. Hedging can be very expensive, especially when the transaction is a large (e.g. a Malaysian company buying airplane engines from Germany that will be delivered in a years time.) In a fixed regime, there would be no need to hedge because business and customers expect no changes in the exchange rate.

After a discussion of the cases for and against both the flexible and fixed regime, the big question is which regime should a country adopt? The answer is that there is no right regime for all countries. It depends on the characteristics of the country itself. It depends on how dependent and vulnerable the country is to external and internal shocks. If a country is more sensitive to external shocks, it will be better for it to adopt a flexible exchange rate system as this will shield (insulate) it better

than a fixed exchange rate system through automatic adjustment as described above the rate will fluctuate to clear any imbalances. However, if a country is subject to internal disturbances, fixing the exchange rate will offer more stability (Frankel, 1999) the exchange rate will remain stable, and reduce the uncertainties that are already caused by internal macroeconomic imbalances such as high inflation or unemployment. An alternate view is the fixed regime should be adopted if the economic disturbances are monetary and have a large effect on the price level, while the flexible regime is more adept at dealing with real problems like changes in consumer tastes abroad that would affect demand for exports (Aziz and Caramazza, 1998).

Bibliography

Aziz and Caramazza. (1998). Fixed or Flexible? Getting the Exchange Rate Right in the 1990's. International Monetary Fund. p.11

Frankel, A. (1999). No single currency is right for all countries or at all times: Harvard University. P9-13

Frankel, A. (2003). Experience of and Lessons from Exchange Rate Regimes in Emerging Economies: Harvard University. P8-11

Froyen, T (1999). Macroeconomics Theories and Policies. New Jersey: Prentice-Hall. P.424-451.

Kenen, B. (2000). Fixed Versus Floating Exchange Rates. Cato Journal.

Lipsey G. (2008). Economics. 13th ed. Boston: Pearson.

Rogoff and Obstfeld. (1995). The Mirage of Fixed Exchange Rates. Journal of Economic Perspectives. 9 (4), 73-69.