What is the main different feature of fixed and floating exchange rate system?
Floating Exchange rate ~
In a free floating mechanism, the external value of a country’s currency is determined by the market forces of demand and supply alone.
Importance
Appreciation = ????
Depreciation = ????
Fixed Exchange rate ~
The currency’s value remained unchanged by market forces.
Revaluation = ????
Devaluation = ???? Explain the advantages and disadvantages of fixed and floating exchange rate.
Fixed exchange rate Advantage ~
1] Exchange rate risk is reduced (NO fluctuation in its currency in terms of other
currency) as easier to forecast and facilitates business planning especially for exporter and importer
2] Anti-inflation which brings from overseas.
Disadvantage ~ 1] Currency may become over-valued or under-valued since it is not based on
market force.
2] Since central bank needs to maintain the fixed rate, its official reserve is largely
used in offset the discrepancy from market. Funds could be used more
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productively elsewhere such as building more basic infrastructure but are already tied up in official reserves.
Floating exchange rate Advantages ~ 1] The price of the currency moves up or down in accordance to market supply and
demand. Currency will be not over-valued or under-valued as according to willingness to
buy and sell. It is fair since it helps to reflect the competitiveness of one nation to another. Example ~
Malaysia (RM) : Singapore (S$)
1988 1.5 1
1 2012 2.4 Answer ~ Singapore has been exporting more to Malaysia for 20 years. 2] It provides a better indicator for investment purpose in terms of which one
nation is strong in international trade or foreign capital flow. If resources are being efficiently allocated between competing uses, market prices (through demand and supply of currency) will accurately reflect the situation. . In 2010, Singapore was the 14th largest exporter and the 15th largest importer in
the world. Primary exports - commodities:
Machinery and equipment (including electronics), computer part, mineral fuels, pharmaceuticals Primary imports - commodities: Machinery and equipment, mineral fuels, chemicals, foodstuffs and consumer goods
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3]
It is sometimes argued that when the exchange rate is freely floated, balance-of-payments surplus and deficits cease to be a problem for the government. The government can simply allow the market forces to ‘look after’ the country’s account. Inflation rates in a competing country will make local market more competitive, hence overcoming the problem of unemployment and economic growth rate. Inflation Export price Foreigners buy less FOREX 4]
Local production Inflation The country monetary policy need not keep official reserves to support deficits because the market will simply fall to correct the disequilibrum.
FOREX Foreigner buy export more as it is cheaper Import > Export
FOREX
FOREX & = Government will not issue treasury bond to support trade deficit
Disadvantage ~ 1] The volatility and instability will slows the growth or even destroy international
trade.
FOREX & = Exporter & Importer would definitely be unknown when the best
time to trade! 2] The argument that freely floated exchange rate can never be over or under valued
depends upon the assumption that the currency is bought and sold only to finance trade. It did not take into account the speculation factor. Reality is that, more than 90% of currency transactions relates to individuals, business, financial institutions and even government’s investment and speculation activities. Too many short term speculative activities resulted in ‘hot money’ that risk the country’s growth.
For instance, if the Singapore $/￡ is 2.5000 – 2.5040 and in speculators think that the S$ is undervalued, they might want to buy S$ in anticipation of the currency appreciation when the future exchange rate is 2.4000 – 2.4040.
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Explain the role of US dollar under managed floating exchange rate system.
1] 2] 3]
Because of its relative stability, USD continues to serve as the major currency.
USD is also often used as a medium of exchange and a unit of account in international markets.
Under the floating system, USD acts as a store of value. 50-60% of all US currency is held abroad. USD is demanded as a store of value because of the political stability of the US and the dollar’s acceptance over time.
Despite its many roles, USD is less important in relative terms today. Other currencies such as the euro, Japanese yen, and the British pound are now used as international reserves
4]
Describe the advantage and disadvantage of controlling currency exchange rate?
Advantages ~ 1] Protect the foreign exchange value of the national currency by preventing
excessive capital outflows. 2] Monitor balance of trade by controlling import without using tariffs or quotas. 3] Government can plan the economy with greater certainty and efficiency. 4] Protect national economy from short term disruption arising from movement of
“hot-money” Disadvantages ~ 1] It causes more bureaucratic regulation 2] It increases administration costs 3] It complicates and delays exchange process 4] It undermines domestic investors’ confidence because difficult for local business
to purchase foreign goods 5] It discourages foreign investment into the country because they are unable to
revert money back to their home country. 6] It creates black market in currencies due to difficulty in getting the currency
needed.
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