Tutorial Week 2

Question: Compare and contrast the fixed exchange rate system and freely exchange rate system. What are the advantages and disadvantages of freely floating exchange rate system versus a fixed exchange rate system? (Explain in great detail with example and diagram if necessary)

What Is an Exchange Rate

Anexchange rateis the rate at which onecurrencycan be exchanged for another. In other words, it is the value of another country's currency compared to that of your own.

Fixed Exchange Rate

Afixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.

Fixed Exchange Rate

If, for example, it is determined that the value of a single unit of local currency is equal to US$3, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level offoreign reserves. This is a reserved amount of foreign currency held by the central bankthat it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market ( inflation/deflation), and ultimately, the exchange rate. The central bank can also adjust the official exchange rate when necessary.

Floating Exchange Rate

Unlike the fixed rate, afloating exchange rateis determined by the private market through supply and demand. A floating rate is often termed "selfcorrecting", as any differences in supply and demand will automatically be corrected in the market. Take a look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing.

Advantages
Stability - Create a stable atmosphere for foreign investment Lower inflation rates and generate demand - Which results from greater confidence in the stability of the currency Trade become easier Do not need large amount of cash to be stored for emergency

Disadvantages
Government may change the rate If so, business sector may become worsen off Peg is difficult to maintain in the long run - Often lead to severe financial crises Other countrys economy problem may affect your country For eg: inflation (explanation continue in next slide)

 U.S prices of goods > U.Ks U.S consumers demand on U.K goods increases U.K consumers demand on U.S goods decreases

- D>S, prices of U.K Good rises, inflation rises.

D 1 D Q

 Since demand of goods in U.S decreased, therefore production will also be decreased, workers will be laid off, hence, the unemployment of U.S will rise. Subsequently, income of U.S people will drop, demand of U.K goods drops due to buying power of U.S people drops. Lastly, the unemployment rate of U.K will also be affected(rise).

Floating Exchange Rate

Unlike the fixed rate, afloating exchange rateis determined by the private market through supply and demand. A floating rate is often termed "selfcorrecting", as any differences in supply and demand will automatically be corrected in the market. Take a look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing.

Advantages
As opposed to fixed, economic condition of other countries will not have effect on own country. - If U.S inflation rises, Demand of U.K goods increases from U.S consumer. This leads to the Demand of Pounds increases. - At the same time, Demand of U.S goods decreased from U.K consumer also. This leads to the Supply of Pounds decreases.

- As Demand increases leads to D>S, for U.K Pounds, value of Pounds appreciate. - At the same time, decreases of supply for U.K Pounds makes the value also appreciate. - As Pounds appreciates, prices of U.K goods will be more expensive for U.S consumer(while it is the same for U.K consumer). - Demand of U.K goods will be decreased from U.S consumer. - On the other side, Demand of U.S goods remains the same because U.K

Advantages
Governments intervention will not be needed. - The action of buying and selling currency to maintain its fixed rate of currency will not be needed anymore. The fluctuation of interest rate will not leads to a serious problem now Including capital flow that leads to fluctuation of currency rate problem is solved. - Since everything is done by the market (Example below)

Example - Lets assume there are only 2 countries A and B. Country A interest rate 12% Country B interest rate 20% - Fund from country A will be withdrawn out and invested in country B.

2 conditions will be happened simultaneously: Interest rate of country A will rise as lack of loanable funds and country Bs interest rate will drop as supply of loanable funds is more than demand. The Demand of currency for country B will be increases and Supply of currency for country A will be increases. This will lead to depreciation of currency of country A and

 As country As currency weaker than currency of country B, the return resulted from convention will be lesser and the cost of capital invested in country B will be increased. As a result, people will invest back in country A as its interest rate(return) is raised now and cost of capital is cheaper. The currency rate and interest rate will go back to equilibrium at the end.

Disadvantages
Trade problems in business sector - More cash balances have to be kept in the bank which earn nothing. Inflation and unemployment may be doubled up - U.S inflation rises, Demand of U.S good drops and USD drops from other countries - This leads to the depreciation of USD which also makes the imported goods prices for U.S people will be rose.

Demand of U.S local goods rises, D>S makes the prices of goods rise. Inflation will be doubled up. - U.S unemployment rises, Imported goods Demand will drop which leads to a drop in the supply of USD. - Drops in Supply makes D>S. USD value will be appreciated. Imported goods Demand will be rose. - This will lead to a decreases in local goods Demand. Production will be reduced and workers will be laid off. Unemployment will be doubled up.