A fixed exchange rate is a system in which a predetermined set of currency values are mutually agreed upon as the exchange rate. The United States dollar was the exclusive currency universally accepted for the exchange of gold and had a dominant position over other currencies. The fixed exchange rate collapsed in 1973 due to the combination of increasing US inflation and a negative US trade deficit, which created speculative pressures on the dollar. Conversely, a floating exchange rate enables the government to regulate the trade balance by adjusting the money supply as necessary. The fixed exchange rate system effectively controls inflation by enforcing monetary discipline and mitigating uncertainty and speculation. The advantages of fixed exchange rates, as opposed to floating exchange rates, are contingent upon the level of interdependence between a country and its neighbouring nations.
In the context of international business, the floating rate system is more appropriate due to its greater stability in exchange rates. This stability helps to regulate the demand and supply of currencies, thereby reducing the risk of interventions. Additionally, under a floating exchange rate system, local inflation does not impact international cost competitiveness. In contrast, a fixed exchange rate system can disrupt trade and investments when currencies depreciate, leading to instability that affects sales, profitability, and revenues. Furthermore, fixed exchange rates are more vulnerable to currency crises, which can create larger economic downturns. However, if a country has strong economic interconnectedness with its surrounding countries, a floating rate system can bring economic stability. Of course, this requires the country to employ economic and monetary policies reasonably.
One of the most important advantages of variable exchange rates is that they make it possible for the government to pursue internal goals without being constrained, such as achieving full employment, maintaining price stability, and maintaining stable growth. Moreover, exchange rate manipulation often serves to accomplish these goals through its automated stabilizing function. Stable exchange rates facilitate international trade and investment, which is a fundamental economic benefit. These two factors have the potential to act as significant accelerators for long-term development, particularly for nations that are still in the process of developing their development. The extent to which a country is dependent on the countries that are located in its immediate vicinity is a significant factor that determines the relative benefits of floating exchange rates in comparison to fixed exchange rates for that country.
A country’s monetary and fiscal independence is not particularly advantageous if its economy is highly reliant on neighbouring countries for investment and trade, and if it would be more prudent for the country to maintain a fixed exchange rate in the face of economic disruptions that mirror those encountered by its neighbors. When a country experiences unique economic disruptions and is economically independent of its neighbours, a floating exchange rate may be a useful instrument for promoting macroeconomic stability. A currency board or currency union can be politically advantageous in a country with a history of fiscal mismanagement because it “ties the hands” of the fiscal and monetary authorities, thereby increasing the difficulty of issuing funds to cover budget shortfalls.
According to Guzman et al., (2018), he claims that floating exchange rates provide a country with monetary policy autonomy through automatic trade balance adjustments and policy autonomy, while fixed exchange rates restrict a country’s ability to adjust its money supply in response to changing demands due to the need to maintain a constant exchange rate. The Integrated Facility Management would agree to currency depreciation if a nation’s trade balance persistently deteriorated and could not be corrected by domestic policy. Opponents of the system assert that a regime with floating exchange rates facilitates a more smooth adjustment process. Some economists believe that when there are mismatches in supply and demand in the foreign exchange markets, a country’s currency will weaken if it has a trade deficit. As the value of the dollar decreases, the trade deficit is anticipated to be reduced as the cost of imports rises and the price of exports escalates for the nation.
A fixed exchange rate is considered a transparent monetary policy anchor due to its simplicity. Citizens of nations with feeble governments can obtain loans from nations that have robust financial institutions. In addition to decreasing exchange rate risk, maintaining a constant exchange rate decreases transaction costs. Due to limited financial resources, economic agents in nations with less developed financial sectors might be unable to safeguard themselves against long-term currency risks.
In contrast, exchange rate fixing permits considerably more incremental fluctuations but still necessitates substantial pricing flexibility within the domestic economy, especially considering the fluctuating movements of capital. The rigidity of fixed exchange rates can significantly impede monetary policy and force governments to implement pro-cyclical fiscal measures in times of recession. Borrowers might be incentivized to utilize the anchor currency as collateral due to fixed exchange rate regulations implemented in nations with high interest rates relative to the anchor currency, which do not protect against exchange rate fluctuations. Fixed exchange rate regimes necessitate the imposition of detrimental capital restrictions by governments as a precautionary measure against currency pressures.
A fixed exchange rate and an open capital market are incompatible with monetary policy independence, according to Ha et al. (2019). A growing number of major emerging market nations have begun to implement policies in recent years that seek to maintain low inflation while preserving the autonomy of their central banks. Unlike when a nation’s monetary policy is determined by an anchor currency nation, variable exchange rates empower a nation to independently pursue its monetary policy objectives. Supporting evidence exists to indicate that nations utilizing floating exchange rates are more adept at mitigating the impact of disruptions and distributing the subsequent costs of adjustment across their domestic and international economies. The implementation of exchange rate fixing also results in a significant reduction or elimination of exchange rate volatility. Volatility insurance diminishes the incentive of financial markets to create hedging mechanisms and financial instruments, thereby facilitating the transfer of risk to the government.
It is recommended that larger emergent market countries adopt more floating exchange rate regimes (Kenen, 2018). As a consequence of their accelerated integration into the global financial system, the financial sectors of these nations are expanding. It has been demonstrated that economies function more robustly and tenaciously when floating exchange rates are involved. A reduction in currency pressure may enable the external sector to shoulder a proportion of the necessary adjustment, thereby preventing an excessive strain on domestic demand. The rapid depletion of reserves caused by unidirectional risk is mitigated by increased flexibility. Floating administrations are necessary for larger economies to address a variety of issues. In addition to robust institutions, sound fiscal and monetary policies are non-negotiable. In economies with variable exchange rates, central bank independence and inflation targeting are crucial, and these nations should take steps to establish a robust system of bank regulation.
The study concludes with a discussion of the advantages that a fixed or floating exchange rate system can offer to international business. In a fixed exchange system, the ability of currencies to achieve local objectives through monetary and fiscal policy without destabilizing their exchange rates is restricted. The lack of emergency restrictions on a fixed exchange rate system is due to the government’s refusal to abandon local objectives in favour of exchange rate protection. Conversely, a floating exchange rate system grants greater autonomy to the system in implementing monetary and fiscal policies to achieve domestic objectives, owing to the autonomous nature of the country’s economy.
Numerous nations have implemented growth strategies that prioritize the stimulation of trade and investment. While the principal emphasis of fiscal and monetary policy remains on domestic objectives such as maintaining stable prices and production, considerations regarding the potential impact on the exchange rate are infrequent. The drawback of fiscal and monetary independence is that it permits governments to implement ill-conceived policies, a matter that has historically plagued developing countries. Floating exchange rates are commonly utilized by countries with negative fiscal and monetary policies as a means of domestic adjustment, which in turn impacts international trade.
References
Alagidede, P., & Ibrahim, M. (2017). On the causes and effects of exchange rate volatility on economic growth: Evidence from Ghana. Journal of African Business, 18(2), 169-193.
Eichengreen, B. (2021). 1. The Endogeneity of Exchange-Rate Regimes (pp. 3-33). Princeton University Press.
Guzman, M., Ocampo, J. A., & Stiglitz, J. E. (2018). Real exchange rate policies for economic development. World Development, 110, 51-62.
Ha, J., Kose, M. A., & Ohnsorge, F. (Eds.). (2019). Inflation in emerging and developing economies: Evolution, drivers, and policies. World Bank Publications.
Kenen, P. B. (2018). 5. Currency Unions and Policy Domains. In Governing the world’s money (pp. 78-104). Cornell University Press.
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