Advantages_&_Disadvantages_of_a_Fixed_Currency_Regime

Advantages and Disadvantage of Fixed Exchange Rate Regimes After the collapse of the Bretton Woods system many exchange rate regimes were created in an attempt to limit the volatility of floating exchange rates. A fixed exchange rate regime is referring to any regime where the monetary authority determines the exchange rate in terms of foreign currency and will trade unlimited amounts at that rate. This includes crawling bands, crawling pegs, pegs with horizontal bands, and fixed exchange rates. As previously noted, currency boards and dollarization are also classified as fixed exchange rate regimes but of a “harder” nature. There are three main advantages to fixed exchange rate regimes27. Firstly, as mentioned in the impossible trinity, a fixed exchange rate gives a country complete control over the stability of the exchange rate. Having a floating exchange rate can lead to volatile swings in the exchange rate which can damage trade and investment. A fixed exchange rate should eliminate this volatility, making for a more stable market. Secondly, it is thought that by pegging the exchange rate to a low inflation currency that domestic inflation will be limited. It is believed that the peg will demonstrate a commitment to low inflation and therefore both the public and private sector will avoid unnecessary inflationary actions. The third advantage to a fixed exchange rate is also related to inflation. By pegging the exchange rate after a period of high inflation it is thought that the fixed rate will “anchor” the inflation. This is achieved through maintaining a fixed nominal exchange rate set at a level below the prevailing rate of inflation28. It must be noted that although a fixed exchange rate will anchor inflation this leads to real exchange rate overvaluation that can have adverse effects on an economy, this will be discussed further in following sections. Having a fixed exchange rate regime also has disadvantages. Primarily, a fixed exchange rate restricts monetary policy29. With a fixed exchange rate it is not possible for the government to intervene and use monetary policy for stabilization. Say for example that Canada has a fixed exchange rate and there is a sudden drop in export demand. With a fixed exchange rate there is no stabilization reaction that would occur under a floating exchange rate30. Under a floating exchange rate a drop in export demand would lessen demand for Canadian dollars and therefore the exchange rate would depreciate making Canadian dollars less expensive to foreign importers. As well, the monetary authority could lower the interest rate in the domestic economy to further stimulate demand. This would make Canadian exports more affordable and export demand would increase, the exchange rate has acted as an automatic stabilizer. Without this function an economy with a fixed exchange rate must reduce output and therefore employment in response to the drop in demand. Losing monetary control of this sort can be very limiting to an economy. Loss of monetary policy is essentially loss of control over the money supply31. Due to the fixed exchange rate, all economic agents are able to exchange their domestic funds for foreign funds whenever they like at the prevailing exchange rate through the central bank. Therefore if the government wishes to change the money supply and economic agents in the economy do not wish to hold more domestic currency they can simply exchange it for foreign currency. The interchangeability of the currency at a known rate makes controlling the money supply very difficult for the monetary authority. Loss of monetary policy can be very constraining to a government. Monetary policy is useful in smoothing out economic fluctuations such as the aforementioned drop in export demand. Without the ability to change the money supply the government is very limited in what actions it can take to lessen the impact of such an event. →Difficulties Maintaining a Fixed Exchange Rate The primary difficulty with maintaining a fixed exchange rate is establishing credibility to convince national and international economic agents that the peg will be maintained. If credibility exists the potential for a speculative attack is greatly reduced. As long as speculators and investors believe that the peg will be maintained, there will not be any speculation against the currency. The previous most widely accepted difficulty with maintaining an exchange rate peg is holding enough foreign exchange to repulse speculative attacks32. If national and international economic agents speculate that the government does not hold sufficient foreign reserves then attacks on the currency may persist. Obstfeld and Rogoff have shown that a speculative attack of any magnitude can be eliminated as long as the monetary authority is willing to forgo any other monetary policy objectives33. The monetary authority must have enough resources to buy back the high-powered monetary base. The monetary base is defined as the total amount of bank notes and coins plus all direct clearers settlement balances at the central bank34. It must be noted that direct clearers are those institutions that have settlement accounts with the monetary authority. Obstfeld and Rogoff show, using data from 1994, that most countries that had a fixed exchange rate during the 1990’s and faced speculative attacks had a ratio over 100 percent of foreign exchange reserves to the monetary base. This demonstrates that the main difficulty to maintaining a peg is not foreign reserves but the credibility to remain committed to the peg. In the event of a speculative attack with a fixed nominal exchange rate, the monetary authority must be willing to allow increases in domestic interest rates35. During a speculative attack short term interest rates will have to rise significantly to support the ongoing rate and limit the outflow of capital. A sharp rise in interest rates can be very damaging to the financial sector of an economy, in particular if that sector is weak. High interest rates make it very difficult for the bank to lend money in the economy. Economic agents will not want to borrow money when rates are so high and banks will suffer from this. This creates a situation of adverse selection; only borrowers who intend to default will borrow at such high interest rates and further increases banks non-performing loans.36 As well, banks themselves will be paying much more interest on any outstanding loans they have, further hurting their bottom line. If high interest rates must be maintained for a significant period of time other parts of the economy will be damaged. Investment will lag due to the high cost of borrowing and this will slow the economy and increase unemployment. If the central bank can make it clear to investors that it will not collapse through the crisis and interest rates will return to normal levels, the crisis can be ended. In conclusion, a fixed exchange rate is technically feasible (holding enough foreign reserves is attainable), the difficulty with such a regime is maintaining credibility. If the government is credible and macroeconomic discipline is maintained there will be no reason for economic agents to speculate against the currency and the peg can be maintained.