Fixed vs Floating Exchange Rates (Arguments For and Against)
Summary
TLDRThis 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
💹 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.
🔄 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.
🌐 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.
Mindmap
Keywords
💡Floating Exchange Rates
💡Fixed Exchange Rates
💡Currency Reserves
💡Monetary Policy
💡Current Account Deficit
💡Trade Deficit
💡Purchasing Power Parity (PPP)
💡Speculative Attacks
💡Devaluation
💡Revaluation
💡Macroeconomic Adjustment
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
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