Exchange rate determinants and economic effects

¶ … fixed and floating exchange rates mechanisms are the exact opposites of one another, the advantages of one are generally the disadvantages of the other. Anyhow, in order to be able to evaluate for each case in part its positive and negative aspects, we should start with defining each, as most of the advantages and disadvantages derive there from.

The fixed exchange rate mechanism refers to a mechanism where "the government (central bank) sets and maintains the official exchange rate)

." The key word in this mechanism is pegging, which means that the currency has a price set against a major currency of the world and that the central bank ensures that this rate is kept throughout the entire period the currency is pegged.

The main advantage in this case refers to stability. Indeed, a fixed exchange rate mechanism helps eliminate or speculative activity on the respective currency. With no more currency risk, the country adopting such a mechanism will have no worries about possible devaluations of its national currency.

This is very important because it creates a certain degree of macroeconomic stability in the country. First of all, foreign investors are encouraged by the economic climate. Indeed, for a foreign investor, the elimination of the currency risk is most important. Generally, foreign investors choose several hedging techniques, in the form of future contracts, for example, to counteract the currency risk. No currency risk is equivalent to a clearance in the administrative measures a foreign investor would otherwise have had to take.

The fixed exchange rate mechanism has its best advocate in the financial crisis of the 90s and the subsequent economic recessions that followed in the areas where currencies encountered dramatic decreases in their price. The example of the Asian Crisis is best known and the nest example in our case.

The crisis began with heavy speculations (many estimated these reached 60 billion dollars) on the national currencies of several countries in South-Eastern Asia, such as Thailand and Malaysia. The excessive speculation on these currencies lowered the price by as much as 50% in some cases (the Thai baht, for example). A fixed exchange rate mechanism would have made this impossible.

Finally, another advantage of a fixed rate exchange mechanism refers to the financial discipline that such a policy implies, with direct implications for macroeconomic indicators such as inflation. This is because the fixed exchange rate mechanism imposes "tight controls on capital flows to and from the economy"

The worst disadvantage that such a mechanism brings about is the unavailability of any response from the central bank in cases of macroeconomic disruptions. Argentina's case at the end of the 90s is the best example in this sense. Pegged to the U.S. dollar, the national currency could no longer truly reflect what was going on in the economy and the economic growth rates had left the local currency highly over appreciated. The country still feels the consequences of what has happened then and the economy has just begun to recover.

The floating exchange rate mechanism presumes that the price of the currency is freely "determined by the private market through supply and demand"

. The most important advantage of such a mechanism is that it provides ways to adjust large deficits in the economy and any other macroeconomic malfunctions. The floating exchange rate mechanism helps, in this case, by allowing the pressure to be "put downward on the exchange rate"

The national government can manipulate the exchange rate of its national currency in order to encourage several trends, such as an increase in exports or a decrease in public deficits. It will do so by selling national currency and, thus, by increasing supply of its national currency on the international markets.