To fix or not to fix - Assignment Example

“To fix or not to fix? ” is a long-standing question in macroeconomics. The issue that sounds deceptively simple has led some countries to face dire consequences by virtue of making a bad choice. The choice of exchange rate regime involves considerations that extend beyond merely the stability of currency prices. This paper juxtaposes the relative merits and demerits of both the regimes and by critically evaluating them leads to the conclusion that no one regime is better than the other. The optimal choice of the regime is relative, depending on various underlying conditions of the economy.

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It has been observed in the past that attempts to defend a fixed exchange rate has translated into extremely costly financial crises e. g. 11 percent fall in Thai GDP in 1998, the Korean crisis in 1997, and Russian crisis in 1998 (Williamson, 2004). The policy measure that governments of overvalued currency resort to is devaluation, but the gains from devaluation take time to materialize while the negative effects set in immediately1 and this often results in a recession. On the other side, there are similar costs of defending an undervalued exchange rate which accrue in the form of inflationary pressures.

This occurs because to support an undervalued exchange rate the authorities would have to decrease the supply of foreign currency which would mean massing its foreign exchange reserves. The flipside of massing reserves means an increase in domestic money supply and thus inflationary pressures. One of the commonly purported merits of a flexible exchange regime is that it acts as a shock absorber that helps to shield the domestic economy against foreign economic turbulence (Ragan, 2001). Let us suppose that recession in the US economy leads to a decline in the demand for Pakistan’s exports.

This will tend to reduce economic activity in Pakistan, but this tendency will be offset by an associated depreciation of the rupee, which will in turn lead to stimulation of exports exports, and a contraction of imports, all of which will help to cushion the Pakistani economy against recession. An analogous mechanism would operate to curb the impact of an initial recession in US. Both cases illustrate the role of exchange rate flexibility in guarding the domestic economy to some degree against international economic instability.

Going by the same token, floating exchange rates also help to diminish our own domestic economic instability. On the policy front, the flexible exchange rate increases the effectiveness of monetary policy, and diminishes the effectiveness of fiscal policy in regulating the economy (Tornell and Velasco, 1995). E. g. an instance requires stimulation of the economy with a view to reduce unemployment. The appropriate monetary policy action is for the authorities to reduce interest rates. This causes a depreciation of the dollar, which in turn encourages exports, discourages imports, and increases net capital inflow.

These exchange rate effects coupled with a cut in interest rate tend to reinforce the initial expansionary impulse. By contrast, in a fixed exchange rate regime monetary policy is quite ineffective. Indeed the rationale of a fixed exchange rate system essentially precludes the conduct of an independent monetary policy. The fixed exchange rate regime answers to this situation is based on the premise of “importing credibility”, which it achieves by to this committing themselves overtly to imitate the monetary policy of the more competent central banks.

But the logic of the argument is far from convincing are weak because it irrationally places a greater confidence in (indirect) exchange rate targeting (Kenen, 2000). Furthermore one rather political argument against the fixed exchange rate regime is that it would mean the domestic economy would be loosing a great deal of democracy as foreigners (the anchor) would be controlling our money. Moreover, in fixed rate regimes, monetary policy must be subordinated by fiscal policy in order to maintain the exchange rate fixed, this effectively ties the hands of the authorities. (Caramazza and Aziz, 1998)

Addressing the same task of economic stimulation via fiscal policy would result in government increasing its budget deficit. The associated upward pressure on interest rates induces an appreciation of the dollar, which in turn discourages exports, encourages imports, and reduces net capital inflow. These exchange rate effects on our international transactions weaken aggregate demand (since imports have increased and exports have decreased) in domestic economy and accordingly tend to offset any expansionary effects of the government’s fiscal program thus fiscal policy under flexible exchange rates is rendered incapable.

By contrast, under a fixed exchange rate regime these adverse secondary effects are precluded, and fiscal policy is likely to be correspondingly more effective (Tornell and Velasco, 1995). Flexible exchange rate regime have been credited with liberating the authorities from bringing the balance of payments (BOP) in to equilibrium as the adjustments in the exchange rates provide for automatic restoration of BOP equilibrium thus allowing the authorities to concentrate more on real variables such as full employment and price stability.

Under fixed exchange rate the BOP deficit is financed by reserves, which implies the ability to bring BOP equilibrium is restricted by the amount foreign reserves. Eventually the reserves are bound to dry out and authorities resort to devaluation, which I believe in essence, is same as the market mechanism of depreciation (barring the fact it is imposed by the authorities themselves rather than market forces). If this is the case the very purpose of having a fixed exchange rate is defeated. According to the common wisdom fixed exchange rate promotes discipline on the policy (Tornell and Velasco, 1995), but this may not always be the case.

This is because even with the fixed exchange rates the authorities still retain some flexibility, such as the ability to shift the inflationary cost of running fiscal deficits from present to future. This is accomplished by allowing external debt to accumulate, or international reserves to diminish until the fixed rate can no longer be sustained. On the other hand, in a flexible exchange rate regime, the cost of an unsustainable policy may be revealed more quickly by movements in exchange rates and prices.

That being the case, a flexible regime may exert an even stronger discipline on policy (Caramazza and Aziz, 1998). A conventional view is that a fixed exchange rate has the advantage of sharply reducing or eliminating exchange rate volatility, this element of certainty will (relatively) reduce transaction costs associated with hedging currency risk. It is also worth mentioning some countries which have less developed financial sectors are ill-equipped with tools to hedge such risks.

This certainty coupled with reduced transaction costs will in turn bolster trade across borders. The flip side of this certainty means inviting speculative attacks (Napolitano and Canale, 2002) as was the case with sterling in autumn 1992, the market perceived it to be overvalued and an impending devaluation was expected. .Under Fixed exchange rate regimes where interest rates are higher than the anchor country, there is an incentive to borrow unhedged in the anchor currency, pressurizing local currency to loose value.

To withstand such pressures under fixed exchange rate regimes, authorities impose capital controls. All in all, a country cannot maintain a fixed exchange rate, open capital market, and monetary policy independence at the same time. Based on the already established arguments and we acknowledge that there is no universally “optimal” regime. Both the regimes have their strengths and weaknesses and the best regime is the one that minimizes the fluctuation in output and prices, moreover one that stabilizes macroeconomic performance.

Furthermore, the choice of regime also depends on the policymakers’ preferences, nature and source of the shocks to the economy and the structural characteristics of the economy. In accordance with that and as well as the empirical evidence (Velasco, 2000), developed economies tend to opt for floating regimes whereas less developed opt for fixed regimes, but by virtue of market imperfections and unexpected crisis in the dynamic economic environment most countries have moved to a mid-way approach “managed – float” thereby reaping the best of both regimes.