Fixed vs Floating Exchange Rates (Arguments For and Against)

Summary

This video explores the pros and cons of fixed versus floating exchange rates. It highlights how floating rates can reduce the need for currency reserves, allow for independent monetary policy, and help correct trade deficits. However, they also bring volatility, which can deter foreign investment. Fixed rates offer stability and lower trade costs but may require high interest rates or reserves, risking economic stability. The video concludes that most economies prefer floating rates with intervention options when necessary, exemplified by China's approach.

Takeaways

• 😀 Floating exchange rates reduce the need for currency reserves, allowing for freer domestic monetary policy.
• 😉 A floating exchange rate can help correct a current account deficit by naturally adjusting the value of the currency to make imports more expensive and exports cheaper.
• 😎 Floating exchange rates are useful for macroeconomic adjustments, such as promoting export growth to boost the economy.
• 😇 In a floating exchange rate system, the currency is less likely to be over or undervalued, as it should reach an equilibrium reflecting purchasing power parity.
• 😓 However, floating exchange rates can be volatile, which may deter foreign investment and complicate trade for domestic exporters.
• 😖 The theoretical self-correction of a current account deficit by a floating exchange rate is often overshadowed by speculative flows in the market.
• 😡 A floating exchange rate might exacerbate inflation issues by lowering the currency's value, which can increase import prices and demand-pull inflation.
• 😌 Fixed exchange rates provide certainty for exporters and importers, promoting investment and simplifying trade.
• 😆 Fixed exchange rates can reduce the cost of trade by eliminating the need for hedging against currency fluctuations in the futures market.
• 😋 Fixed exchange rates encourage domestic producers to increase efficiency and innovate to maintain competitiveness without relying on currency devaluation.
• 😟 Fixed exchange rates can have negative macroeconomic consequences if interest rates are used to maintain them, potentially leading to reduced growth and higher unemployment.
• 😨 There is a risk of speculative attacks on fixed exchange rates, which can destabilize the system and devalue the currency if not managed carefully.

Q & A

Why might a country choose to adopt a floating exchange rate?

A country might adopt a floating exchange rate to reduce the need for currency reserves, allow domestic monetary policy to work freely without manipulation of interest rates, and enable the exchange rate to naturally correct a current account deficit by making imports more expensive and exports cheaper.

What are the potential benefits of a floating exchange rate for a country with a current account deficit?

A floating exchange rate can help partially correct a current account deficit by decreasing the value of the currency, which makes imports more expensive and exports cheaper, potentially improving the trade balance.

How can a floating exchange rate serve as a useful tool for macroeconomic adjustment?

A floating exchange rate can be used to prop up an economy by reducing the value of the currency, which can stimulate export growth and, in turn, increase general economic growth.

What is one of the key theoretical benefits of a floating exchange rate according to the script?

One key theoretical benefit is that a floating exchange rate should reach an equilibrium reflecting purchasing power parity, which means the currency is valued perfectly without being over or undervalued, reducing the risk of speculative attacks.

What are some issues associated with floating exchange rates?

Issues with floating exchange rates include the lack of guarantee for stability, which can reduce incentives for foreign investment and trade due to volatility, and the theoretical correction of a current account deficit may not occur in reality due to factors like speculation.

How can high inflation affect the effectiveness of a floating exchange rate?

High inflation can cause a country to struggle with exports, leading to a downward pressure on the exchange rate. However, a lower exchange rate can worsen the inflation problem by increasing import prices and demand-pull inflation.

What are the benefits of a fixed exchange rate in terms of trade and investment?

A fixed exchange rate reduces exchange rate uncertainty, promoting investment and making trade easier by providing a stable exchange rate environment for exporters and importers.

How does a fixed exchange rate system provide flexibility?

A fixed exchange rate system allows for some flexibility by having a band within which the exchange rate can move up and down, and governments can devalue or revalue the currency within agreed limits.

What are the potential drawbacks of using interest rates to maintain a fixed exchange rate?

Using interest rates to maintain a fixed exchange rate can lead to negative macroeconomic consequences such as reduced growth and higher unemployment if interest rates are raised to meet the fixed rate.

Why might a government face challenges in maintaining large levels of foreign currency reserves for a fixed exchange rate?

Maintaining large levels of foreign currency reserves can be expensive and not viable for some economies, which could lead to the collapse of the fixed exchange rate system.

What is the general trend in the world regarding exchange rate policies, and how do governments balance the two systems?

Most economies prefer floating exchange rates for their flexibility, but governments often allow room for intervention to address issues with floating rates, providing a balance between the two systems.

Outlines

00:00

💹 Advantages of Floating Exchange Rates

This paragraph discusses the benefits of floating exchange rates, which include reduced need for currency reserves, allowing for independent domestic monetary policy, automatic correction of current account deficits, and the potential for exchange rate adjustments to boost economic growth. It also touches on the equilibrium nature of floating rates, which can lead to less speculative attacks and more stability. However, it also points out the risks of volatility, which can deter foreign investment and complicate trade for exporters.

05:03

🔄 Challenges of Floating and Benefits of Fixed Exchange Rates

The second paragraph addresses the issues associated with floating exchange rates, such as the unpredictability of exchange rate fluctuations and their potential to exacerbate inflation and trade deficits. It then contrasts these with the benefits of fixed exchange rates, which include reduced uncertainty for trade and investment, cost reduction in hedging, and the discipline it imposes on domestic producers to increase efficiency and innovation. However, it also highlights the potential downsides of fixed rates, such as the negative macroeconomic impacts of interest rate manipulation and the difficulty of maintaining large foreign currency reserves.

10:03

🌐 Global Perspective on Exchange Rate Policies

The final paragraph provides a global perspective on exchange rate policies, noting that while most economies prefer floating rates for their flexibility, there is an acknowledgment of the need for government intervention to address issues that may arise. It mentions that countries like China intervene in the market when necessary and emphasizes the importance of being prepared to discuss these topics, especially in the context of essay questions in exams.

Keywords

💡Floating Exchange Rates

Floating exchange rates refer to a system where a country's currency is allowed to fluctuate freely in response to market forces of demand and supply. In the video, it is discussed as a system that reduces the need for currency reserves, allows domestic monetary policy to operate freely, and can help correct a current account deficit. However, it also comes with the risk of volatility, which might deter foreign investment and complicate trade.

💡Fixed Exchange Rates

Fixed exchange rates are a monetary system where a currency's value is fixed to another single currency, a basket of currencies, or to another measure of value such as gold. The video outlines the benefits of fixed rates, such as reducing exchange rate uncertainty and promoting trade and investment. However, it also points out the potential drawbacks, including the need for high levels of currency reserves and the risk of speculative attacks.

💡Currency Reserves

Currency reserves are the foreign currency assets held by a central bank or other monetary authority. In the context of the video, maintaining fixed exchange rates requires substantial currency reserves to intervene in the market and stabilize the currency's value. The script mentions that this can be costly and may not be viable for all countries.

💡Monetary Policy

Monetary policy refers to the actions of a central bank or monetary authority that determine the size and composition of the money supply, which in turn affects interest rates and inflation. The video explains that with floating exchange rates, a country has more flexibility in its monetary policy, as it does not need to manipulate interest rates to maintain a fixed exchange rate.

💡Current Account Deficit

A current account deficit occurs when a country's imports of goods, services, and transfers are greater than its exports, resulting in a net outflow of funds. The video script discusses how a floating exchange rate can theoretically help correct a current account deficit by making imports more expensive and exports cheaper, thus reducing the deficit.

💡Trade Deficit

A trade deficit happens when a country's imports exceed its exports. The video mentions that a floating exchange rate can help correct a trade deficit by depreciating the currency, making exports more competitive and imports less attractive, although it also notes that this is mainly theoretical and not always practical.

💡Purchasing Power Parity (PPP)

Purchasing Power Parity is an economic theory that compares different countries' currencies through a 'basket of goods' approach to determine their relative value. The video script suggests that in a floating exchange rate system, the currency should reach an equilibrium that reflects PPP, meaning it is neither overvalued nor undervalued.

💡Speculative Attacks

Speculative attacks refer to the act of investors betting against a currency, often in the context of a fixed exchange rate, with the expectation that the currency will be devalued. The video warns that fixed exchange rates are more susceptible to such attacks, which can destabilize the currency and the economy.

💡Devaluation

Devaluation is the official reduction in the value of a country's currency relative to another single currency, gold, or a basket of currencies. The video script explains that under a fixed exchange rate system, a government can devalue its currency to adjust the exchange rate within an allowed band, but this is often seen as a sign of economic weakness.

💡Revaluation

Revaluation is the increase in value of a currency relative to other currencies. In the video, it is mentioned that a government can revalue its currency under a fixed exchange rate system, but this also carries political implications and can be seen as a sign of weakness if done frequently.

💡Macroeconomic Adjustment

Macroeconomic adjustment refers to the process by which governments or central banks influence the economy through various means, such as monetary or fiscal policy, to achieve desired economic outcomes. The video script describes how a floating exchange rate can be a useful tool for macroeconomic adjustment, as it allows for the currency to depreciate and thus potentially boost export growth.

Highlights

Floating exchange rates reduce the need for currency reserves, allowing for more flexible domestic monetary policy.

Floating rates enable automatic correction of current account deficits by adjusting the currency value.

Floating rates can be a useful tool for macroeconomic adjustment, supporting growth through export demand.

Floating exchange rates tend to reach an equilibrium reflecting purchasing power parity, reducing the risk of speculative attacks.

Volatility in floating exchange rates can deter foreign investment and complicate trade for domestic exporters.

The theoretical automatic correction of current account deficits by floating rates is often overshadowed by speculative flows.

Floating rates may exacerbate inflation problems by lowering the currency value and increasing import prices.

Fixed exchange rates provide stability, reducing uncertainty for exporters and importers and promoting investment.

Fixed rates allow for some flexibility, with the possibility of devaluing or revaluing the currency within a band.

Fixed exchange rates eliminate the need for hedging in the futures market, reducing trade costs.

Fixed rates encourage domestic producers to increase efficiency and innovate to maintain competitiveness.

Using interest rates to maintain a fixed exchange rate can have negative macroeconomic consequences.

Maintaining a fixed exchange rate may require unviable levels of foreign currency reserves.

Fixed exchange rates are susceptible to speculative attacks that can destabilize the system.

Most economies prefer floating exchange rates for their flexibility, but allow for government intervention when necessary.

China exemplifies government intervention in floating exchange rates to address concerns.

The video aims to prepare viewers for potential essay questions on the topic of exchange rates.

Transcripts

hi everyone a massive bit of theory

right here looking at the advantages and

the disadvantages of fixed and floating

exchange rates putting them both against

each other and trying to work out which

one is better right this is a big big

deal here and some of the arguments are

not simple so what I'd recommend is

basically copying down everything on

this board right now leaving lots of

space to write extended writing to

explain some of these points carefully

and hopefully by the end you'll be

Crystal Clear how to argue a case if a

big essay question came on this topic in

your exam let's start by looking at

floating exchange rates why might a

country want to adopt a floating

exchange what are the benefits well one

it reduces the need for currency

reserves we know that when it comes to

uh maintaining fixed exchange rates

central banks or governments need to

have large levels of currency reserves

domestic currency yes but foreign

currency as well which might not be

viable and is very costly with a voting

exchange rate no need no need to mess

around uh withholding lots of currency

reserves which is good it means that

domestic monetary policy can work freely

some fixed exchange rate systems will

require the manipulation of interest

rates in order to keep uh an exchange

rate fixed to a certain currency whereas

in a FL exchange rate no need to worry

about changes in interest rates to keep

an exchange rate fixed no worry you can

use monetary policy to deal with

domestic issues in the economy whether

it's inflation low growth high

unemployment whatever it might be

number three is quite an interesting

point and I've made already a separate

video on how a floating exchange rate

naturally can help partially correct a

current account deficit automatically

that's one of the key benefits uh of a

um floating exchange rate take a a

country which has a large current

account deficit or a large trade deficit

that implies that net exports are

negative there is more supply of the

current of the currency in terms of

buying in Imports than there is demand

for the currency so on a very simple

currency diagram Supply is Shifting to

the right which is lowering the value of

the exchange rate as a result of imports

more than exports but an author exchange

rate increases the supply of the

currency that will reduce the value of

the currency making Imports more

expensive and exports cheaper which in

theory can help partially correct a

trade deficit or a current account

deficit so that's one of the big

benefits it's automatic correction if

you want more detail on that watch my

video on how a floating exchange rate

can automatically correct a current

account deficit

uh this is an interesting uh Point here

oh I mentioned that point sorry as

number four let's go back to number

three it's a useful tool very basically

for macro adjustment as I've just said

um reduction in the value of the

exchange rate can help prop up an

economy so uh if the exchange rate fell

for some reason then that could help

prop up uh export growth in the country

which can help increase General growth

in the country so for countries that are

already export dependent they can rely

on a fall in the exchange rate to make

maybe increase export demand and exports

um so it can be very useful to just help

solve maybe low growth issues in the

economy if the exchange rate Falls then

you're going to have that benefit and

number five here there are less chances

in a floating exchange rate for a

currency to be over or undervalued in a

floating exchange rate system exchange

rate should reach an equilibrium which

reflects purchasing power parity in that

sense the currency is valued perfectly

not over or undervalued therefore the

risk of speculative attacks especially

currency is overvalued are less likely

to occur but even if a currency is

undervalued are less likely to occur

hence uh more stability is likely in

that sense with the exchange rate being

in equilibrium at the correct level uh

more understanding on PPP can be found

on my video uh real exchange rates and

purchasing power

parity however what are some issues with

fusing exchange rates well there is no

guarantee that F exchangers will be

stable they're left open to the forces

of demand and Supply who knows the

exchanger can go up and down it can be

very volatile and the problems with that

is that it can reduce the incentives for

uh foreign investors or foreign

companies to actually invest in the

domestic country where the exchange rate

is very volatile it puts off investment

foreign investment it puts off trade as

well so for exporters domestically it

becomes harder to trade because foreign

countries don't really know what they're

getting in terms of currency with uh the

domestic currency constantly going up

and down so that's a problem there

reducing some of the train benefits when

there is high volatility and also when

we talk about this sell correction

number four here of a current account

deficit that's actually a point that's

mainly theoretical in reality it's

unlikely to occur why because imports

and exports uh are only two of the

factors that can affect demand and

supply for a currency there are loads of

other factors that are way more dominant

like speculation in fact speculative

flows are way more likely to affect

demand and supply and change the

exchange rate value than uh a current

account deficit it is um so in that

sense the demand for imports demand for

exports uh fair enough that can have an

impact on thechange rate and nowhere

near as big as speculation which can

actually stop the number four point here

occurring so that limits the the value

of a floating exchange

rate we can also bring in the concern

about inflation rates so think about an

economy that's suffering because of high

levels of inflation and as a result it's

struggling to export which maybe means a

net EXP a negative what we've said

already that that's going to put

downward pressure on the exchange rate

because the supply of the currency is

going to be be is going to be increasing

more than demand for the currency which

lowers the exchange rate while in trying

to correct the trade deficit problems

the lower exchange rate will actually

push up inflation again so if High

inflation is causing a problem of reduce

export competitiveness a lower exchange

rate could actually worsen the inflation

problem through higher import prices and

through higher demand inflation as well

so there is a risk that comes about from

a floating exchange rate with inflation

as well what about a fixed exchanger

well a fixed exchange has got benefits

in terms of lowering the exchange rate

uncertainty um exporters and importers

know that with this exchange rate it's

going to be fixed at a certain level

it's going to be stable which promotes

investment foreign investment into the

country but it also makes trade a lot

easier exporting and importing in that

respect some flexibility is permitted in

my previous video on fixed exchange

rates I assumed that the exchange rate

chosen was at a at one specific point

reality countries that adult fixed

exchange rates will often have a band by

which the exchange rate can very simply

move up and down within the band doesn't

have to State one specific point so some

flexibility there but also if a

government wants to reduce the exchange

rate value it can just devalue the

currency or if it wants to increase the

value of the currency it can revalue it

as long as other countries agree with it

but the problem with doing that even

though in theory that seems fine it's

politically that's not really accepted

it's a sign of weakness if the

government has to revalue or devalue a

fixed exchange rate but in theory it can

occur and there is some flexibility

there reducing the cost of trade is

another major benefit here

um if uh people involved in trading

industry so in uh uh in exporting

Industries importing Industries people

involved to protect against um kind of

unstable floating exchange rates what

they might do is actually buy in the

future exchange rate market so let's

take a foreign country that wants to buy

domestic Goods let's take the UK for

example which maybe has a floating

exchange rate foreign countries who are

not sure about the value of the UK pound

might hedge against whether the pound

will actually rise in value which will

make uh buying Imports more expensive

for the foreign

country what they might actually do

therefore is Buy in the future in the

future's exchange rate market so buy now

even though buy pounds now even though

they actually want to buy the Imports or

exports UK exports even though they want

to buy them a long time in the future

they might actually buy their pounds now

to hedge against the potential rise in

the UK pound and that's very costly to

buy and to get involved in the future's

exchange rate Market is expensive it

incurs an extra cost um so in that sense

if you have a fixed exchange rate there

is no need to hedge there is no need to

buy a pounds or any currency in the

Futures Market which is more expensive

and that reduces the cost of trade for

for importers especially they don't need

to worry about whether the exchange rate

or the currency they're actually buying

will rise in value in the future no

worries about that so no need to

actually get involved in the Futures

market and to hedge against

it and also a fixed exchange rate puts

discipline on domestic producers they

know now that they can't rely on an

exchange rate falling in value they know

their exchange rate is fixed therefore

if they are to maintain competitiveness

the only way they can actually do it is

to increase efficiency to in best to get

involved in R&D to look at Innovation

that's the only way to increase

competitiveness to increase

efficiency it makes them disciplin in

that sense which is a good thing for

them and for the whole economy and for

consumers too who might benefit from

lower

prices but there are major issues with

fixed exchange rates number one if

interest rates are being used to

maintain a fixed exchange rate then we

know let's say uh the fixed exchange

rate is set at a level where the current

exchange rate is lower then the F the

exchange rate needs to rise to meet the

fixed exchange rate which may mean

raising interest rates well raising

interest rates may well get the fixed

the exchange back to the fixed level but

it may come with major negative

consequences of reduced growth of hire

unemployment Etc it can have very nasty

macroeconomic consequences so that's not

a good thing if interest rates are used

to uh uh maintain a fixed exchange rate

uh we also need to question whether

large levels of foreign currency

reserves can actually be held by central

banks and governments to maintain a

fixed exchange rate if it's not interest

rate LED which often it won't be if it's

currency Reserve LED and maintained in

that way can an economy can a government

actually hold large levels of foreign

currency Maybe not maybe it's too

expensive maybe it's not viable for them

in which case this whole system will

collapse and finally we can also be

concerned about speculative attacks with

a fixed exchange rate there is no

guarantee that the exchange rate that is

decided is actually going to be the

correct purchasing power value maybe

it's going to overvalued maybe it's

going to be undervalued in which case a

chance a speculative attacks that can

really destabilize the whole system is

quite likely and that can again destroy

the system and it can destroy the value

of the currency if you're not

careful therefore what do we tend to see

in the world While most economies

nowadays agree that the merits of

floating exchange rates outweigh the

merits of fixed exchange rates but there

are still major concerns about some of

the uh uh the issues with floating

exchange R so what you tend to see is

floating exchange rates the majority of

the time but if there are issues with

the exchange rate then governments allow

room for the for themselves to intervene

and to solve potential issues so that

kind of gives them the best of both

really majority of the time floating

exchange R but if they need to get

involved there is room to do so room for

maneuverability you can say uh to

actually intervene in markets if they

need to China is a good example of

intervening Lots if they're not happy

with the floating exchange rate thanks

very much for watching guys really

important stuff there you may want get

an essay question on this if so you need

to be prepared to answer it hopefully

this video has done it for you thanks

for watching see you all next

time