Impact of exchange rate on the economy

A country’s exchange rate is explicitly the currency value at which it transacts business with other countries around the world. It determines how much would be an equivalent of its currency which would be used to purchase goods and services from other countries around the global world. The world is a global market that needs a form of agreement in terms of currency at which it trades. The essence of a fixed exchange rate system is to maintain a country’s currency value within a very narrow band. This is also regarded as ‘pegged exchange rate’. The exchange rate in question depends on the form or type which the government of the country chooses to adopt or to use.

OBJECTIVE

To discuss issues as they will affect certainty in international trade when all countries adopt a fixed exchange rate. The issues to consider include:

Types of exchange rate

How exchange rate changes

Impact of exchange rate on the economy both nationally and internationally

Understanding of fixed exchange rate from demand and supply perspective.

IMPACT OF THE ADOPTION OF A FIXED EXCHANGE RATE ON INTERNATIONAL MARKET.

In the history of financial world there exists various international monetary systems and foreign exchange rate which not only manage domestic economy of country but also international trade issue. These include:

Fixed rate

Floating rate

Forward rate

Spot rate

Future rate

Amongst these, we shall critically examine the fixed rate and how it can affect international trade as a whole.

FIXED RATES

According to the writer of ehow found on http://www.ehow.com/list_6804540_types-foreign-exchange-rates.html viewed on 30/12/10 it writes ‘The smaller economies of developing countries adopt the use of fixed foreign exchange rates for trading and to attract foreign investments. By fixing its currency against the currencies of other countries, a country keeps export prices affordable and easy to international buyers and allows for trade surplus over time.

Fixed currency rates also allow a country to assure foreign investors of the stable value of their investments in the country. However, under fixed rates, the monetary policies of a country can become ineffective when trying to stimulate domestic economic activities by consumers at the host country. Injecting more money into the economy would normally reduce a country’s currency value against foreign currencies under floating rates. As imports become more expensive, consumers would gradually focus their demand on domestic products, potentially lifting up the economy. With fixed rates, however, the exchange value of domestic currency does not move and more money means more buying power for imports. Such an outcome does not achieve policy makers’ intention to increase domestic demand’. This is expedient in order to ensure that there is a close gap which would assist balance of payment; the international economy would be appreciative of a fixed rate of exchange as it would allow for free flow goods and services at a predicted price.

(Reference: http://www.rba.gov.au/publications/confs/1993/intro-93.pdf assessed on 30/12/10)

From the above citation from Adrian, it is obvious that fixed exchange rate has its benefits too which would help the international market. Below are some of the merits and demerits of the fixed exchange rate.

MERITS OF FIXED EXCHANGE RATE

1. It reduces fluctuation in the value of currencies which can cause problems for firms engaged in Trade. When exchange rate is fixed, it allows for comfort in the desire of the foreign customers who wants to trade with the host country as they would know that the price agreed on for the commodities at the stated time would still be at a given exchange rate. Though the price of the commodity might change, but the exchange rate is known.

2. It allows for foreign firms to invest in countries where fixed exchange rate occurs. Some Japanese firms have said that the UK’s reluctance to join the Euro and provide a stable exchange rates make the UK a less desirable place to invest.

3. When the cost of import and export increases, it will therefore increase the income of the host country and the other countries involved.

4. A well monitored exchange rate would assist the domestic companies to sell out there products to the international world without fear of pressure from exchange rate differences, thereby increasing the domestic market and encouraging the local manufacturers to produce more of their products which would be used for international trade.

5. Fixed exchange rate reduces drastically the expectations of inflation in an economy. Inflation is reduced to a minimal if not zero. This is due to the fact that the one of the major factors that would have allowed for inflation which is differing exchange rate is absent.

DEMERITS OF FIXED EXCHANGE RATES

1. To maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives.

2. It is difficult to respond to temporary shocks. For example an oil importer may face a balance of payments deficit if oil price increases, but in a fixed exchange rate there is little chance to devalue.

3. It requires government intervention when there exists too much money in circulation and the fixed rate is affecting the country’s currency adversely.

4. In order to check the problems that may accrue to the country’s currency, the central bank with the government may have to increase interest rate which may not be conducive to the citizenry, leads to unemployment and might lead to recession.

(Reference: http://www.economicshelp.org/macroeconomics/exchangerate/advantages-disadvantages-fixed.html assessed on 30/12/10)

CONCLUSION

From the above mentioned issues on foreign exchange basically on fixed and floating foreign exchange, it is obvious that the floating system of exchange would be better off as the dangers of fixed would be avoided. This is also the system widely used by most countries i.e. the floating exchange rate as it helps to readjust during inflation and deflation. Under a system of fixed exchange rates balance of payments equilibrium is disturbed by a fall in export sales. When the supply curve of foreign exchange moves sharply and the authorities do nothing, an excess demand for foreign exchange will come on the market and thereby causing the exchange rate to rise which means the home currency would depreciate. In order to guard against such happening the home authorities must enter the market, and close the gap by supplying foreign exchange from reserves. Thus the home currency may be supported at cost to the country’s reserves. This would drastically affect the financial reserve of the country.

However, the implication of the adverse effect on the domestic market is also very crucial. But this is where the government intervention now matters. The government of the concerned countries would buy the currency which is in excess from the market so as to avoid deflation of its currency which could lead to a devastating market economy. A good example is the government of Australia as written by Adrian Blundell-Wignall. He wrote ‘Australia’s economic relations with the rest of the world have undergone profound change over the past decade. The floating of the exchange rate opened goods markets to greater international competition and Australia’s pattern of international trade changed considerably. Concomitantly, increasing integration into world financial markets saw Australia drawing more heavily on foreign capital. In the past 15 years, two broad developments in the world economy have been particularly significant for Australia: financial market liberalisation and the emergence of the newly industrialising countries in Asia. From the late 1970s, financial liberalisation (and, in particular, the removal of capital controls) made financial markets increasingly globalised. At times, these developments were associated with speculative capital flows that undermined attempts to reconcile managed exchange rates with domestic macroeconomic objectives. At the end of 1983, against the background of more general moves to deregulate the financial system, the Australian dollar was floated.

Australia is a small commodity exporting country, subject to significant terms of trade shocks driven by the world commodity price cycle. Once the currency was floated, the nominal exchange rate was able to respond more rapidly to these external shocks, helping to cushion the domestic economy from the inflationary and deflationary pressures to which they gave rise. For example, falls in the terms of trade have been associated with real depreciation which has reduced the negative income effects of the terms of trade decline on exporters and has added stabilising stimulatory influence to the domestic economy. While movements in the currency have been largely driven by commodity prices, it is widely felt that the depreciation in the mid-1980s went beyond that justified by fundamentals.

While the real exchange rate recovered in the second half of the 1980s and fell again in the early 1990s, in line with the behaviour of the terms of trade, the overall trend in the past two decades has been one of real depreciation. This downward trend in the real exchange rate occurred at a time when Australia also began to cumulate significantly larger external deficits, so that foreign debt was rising as a share of income. This too can be linked to the globalisation of world capital markets. The greater degree of integration of Australia into world financial markets meant that it became easier to attract capital from the rest of the world to finance investment independently of the level of national saving. There were two major investment booms in the 1980s associated with high real exchange rates and current account deteriorations. The first occurred around the time of the second oil price rise in the late 1970s/early 1980s, and resulted largely from improved prospects for the energy and minerals sectors. The second was associated with the asset price boom later in the decade. Both episodes were accompanied by a build-up in Australia’s foreign liabilities and were followed by a world recession and falling commodity prices.