Financial and Monetary Economics Since

Financial and Monetary Economics

Since the end of World War II the issue of floating exchange rates in regards to currency has been increasingly brought to the forefront. Part of the reason for this is because the Breton Woods Agreement of 1944 established the dollar as the strongest currency in the world. Where, the greenback and other major currencies would be backed by the gold standard. Until.the1970's, this fixed rate currency system would serve as a way of providing the world with stable economic growth and low inflation. However, by the late 1950's and into the 1960's a shift would occur in this policy, where Europe and Japan were able to rebuild after the war, quickly become industrial power houses. (Breton Woods Agreement, 2010) Then, when you combine this with President Johnson's refusing to raise taxes to pay for spending on the Vietnam War and his Great Society programs, meant that the U.S. would begin to run a trade deficit. This was problematic because the gold standard was always used to support the dollar, with increased amount of capital outflow, meant that defending the dollar against speculative attacks would become less effective. As a result, the total amounts of gold that was backing the U.S. dollar would continue to decline. This is significant because it would underscore a shift that would occur in the way currencies trade with one another, where a new agreement would be created that would allow the major currencies of the world to float against one another (Breton Woods II). Since that time numerous countries around the globe have used either the fixed or floating exchanges rates as a part of their national monetary policy. (Roubini, 2008) Yet, the various economists will continue to debate as to the overall effectiveness of either system. To fully understand the benefits along with drawbacks of the fixed rate monetary system in relations to a floating rate system requires: providing a general overview of each system, why fixed exchange rate system are unstable, why the floating exchange rate systems are subject to volatility and looking at examples of the effects of both in the real world. Together, these different elements will provide the greatest insights as to what are the overall benefits and drawbacks of each type of monetary system.

Overview the Fixed Exchange Rate System

A fixed exchanged rate is where the central of bank of a given country will decide to peg their currency to some kind of precious metal such as: gold or to a currency / basket of currencies. This is because, as the country is developing the fixed exchange rate policy, it will allow the various imports and exports to remain more competitively price, especially if the peg is set low. Over the course of time, this will help the developing country to be able to increase the overall number of exports that they are selling in a particular country; because the various goods are cheaper. At which point, this would cause the developing country to begin to experience trade surpluses, which can be used to help increase the overall amounts of foreign investment capital. Once this takes place, it means that the government can begin spending the surplus and the foreign capital on developing infrastructure as well as modernizing their economy. The idea is that by engaging in such policies, a developing country can be able to quickly build their economy and the standard of living for the people. At which point, the fixed rate would more than likely be removed once the economy begins to mature. A good example of this can be seen in China, where they have been growing dramatically over the last 15 years. The problem is that they have kept the fixed exchange rate on their currency (the yuan) low against the dollar. In 2005, the U.S. along with other countries pressured them to loosen the peg and begin using fixed rates on other currencies. However, the global financial crisis has meant that Chinese imports into the United States have declined by 25.7% and there are a total of 23 million unemployed factory workers. As a result, China has once again lowered their peg against the dollar. (Wang, 2009) This is significant because it shows how the developed nations are trying to encourage China to abandon the fixed rate system. Yet, they are reluctant because engaging in such activities could have short to medium term impacts on their economy. To try and keep exports competitive, the central bank decided to lower the fixed rate relative to the dollar.

Benefits vs. Drawbacks of the Fixed Exchange Rate Policy

The fixed exchange rate system has a number of different benefits and drawbacks. Some of the most notable benefits would include: it reduces the risks of trading / investing in a particular country. While the drawbacks would include: it can create deflationary bubbles. (Fixed vs. Floating Exchange Rate, 2007) When looking at the benefit, it reduces the risks of trading / investing, it is clear that a fixed rate currency policy helps to instill confidence among businesses and investors. This is important because the confidence of both groups is necessary for large amounts of trade to take place and for investments into various: plants, equipment as well as infrastructure. When a country is rapidly growing, if you allow the currency to float freely against the major currencies of trading partners, this can cause a particular nation to not see the benefits of increased trade. This is because their currency could be subject to large increases, which would make the various goods and services sold abroad more expensive. Over the course of time, this can work like economic aid in reverse, where the emerging country will experience large trade deficits at the hands of their trading partners. This makes the financial position of the country more unstable, as these large amounts of debt will affect the ability of the government and businesses to borrow on the world markets. When you are using a fixed rate currency policy, this will mitigate these effects, as exports remain more competitive with trading partners. Once this takes place, it means that the developing country will begin to experience trade surpluses, which can be used to build infrastructure and create jobs. Over the course of time, this will improve the standard of living within a particular nation. A good example of this can be seen in Japan during the 1960's and 1970's, where the fixed rate policy allowed the industrial base of the economy to rebuild after the war. This helped the country to begin to experience trade surpluses that would improve the standard of living, making them one of the top economic powers in the world. (McKinnon, 2005)

When examining the drawbacks of a fixed rate policy, it can cause deflationary bubbles, it is clear that maintaining the policy of fixed exchange rates for to long can lead to deflation. This is because maintaining the fixed rate can cause the forces of supply and demand to build up. Where, the government will defend the currency against any kind of speculative attempts to drive the price of the currency up. Over the course of time, this will cause these forces to become more extreme, where a rise in the currency or assets that the developing country's currency is tired to, could help fuel this deflationary bubble. This is because the major currency that they are pegged against it could begin to experience sharp increases. In some cases, commodities prices could be quoted in the exchange rate of this currency (such as the dollar). When this happens it means that raw materials will become more expensive for the developing country, which helps to fuel inflation. As the asset bubble becomes larger, the central bank is forced to revalue the currency to maintain some kind of balance in the economy. Once this takes place, it causes the country's currency to be the subject of speculative raids that will attempt to address the pent up supply and demand. At which point, the central bank will have the asset bubble burst, followed by a round of severe deflation. A good example of this can be seen in Argentina during 2001, where the country maintained a fixed rate against the U.S. dollar. When the dollar rose sharply from 1995 onward, this would cause prices for various raw materials and natural resources to rise. At which point, the government would attempt to adjust the rate with no success. Eventually, the central bank would be forced to abandon this policy, which would spark deflation, as the forces of supply and demand were balancing out. (Frankel, 2002)

Overview of the Floating Rate Exchange System

In general, the floating rate exchange system is when the central bank of a particular country will allow their currency to float freely against the different currencies of the world. The idea is that such a system will promote the long-term stability of country's monetary policy; by allowing the forces of supply and demand to determine what would be the most appropriate exchange rate. During times of extreme pressure from the supply or demand side, the central bank is prepared to go in and support the currency, to help provide stability. This is significant because traders around the world; will use the major currencies as a way to hedge themselves against different risks. Where, they will view the weakness of one country's currency as a sign that they could be facing a number of different economic challenges. (Fixed vs. Floating Exchange Rate, 2007) a good example of this can be seen with the British pound, where the Bank of England decided to keep interest rates at .5%. This is important, because the increase in rates could be seen as a sign that economic stability could be returning to the country, which would help to reverse the downward pressure on the pound. However, the fact that they decided to keep interest rates unchanged, means that many traders / speculators will continue to place pressure on the currency. This is because of the perception that economy is not performing as well as the rest of the world. As a result, traders and speculators will sell the pound while buying another major currency such as the Japanese yen or U.S. dollar. (Bank of England's Decision Affects Pounds Performance, 2010)

Benefits vs. Drawbacks of the Floating Exchange Rate Policy

There are a number of different benefits and drawbacks that the floating exchange rate system offers. The most notable benefits would include: it allows the government to have greater control over the economy. The drawbacks of the floating rate system would include: it allows the country's currency to be subject to extreme amounts of fear and greed. (Fixed vs. Floating Exchange Rate, 2007) When looking at the benefit of the floating rate system, it allows the government to have greater control of the economy, it is clear that such a system can be used to effectively maintain the balance between the forces of supply and demand, within the currency markets. This is because the lack of intervention from the government, allows the free market to function most effectively. Over the course of time, this policy will allow the economy to be protected from outside shocks that could occur (such as a sharp rise in commodities prices). This allows the central bank to have greater control when setting interest rate policy, as they can respond naturally to what the forces of supply and demand are dictating. Once this occurs, the government has greater control of the economic agenda, where they can set policies (i.e. taxation) that can address any kind of trade surpluses or trade deficits in real time. At which point, the long-term stability of the economy is more balanced, because the government is able to effectively control these two issues. A good example of this can be seen in Japan, where they were able to effectively manage their currency to create a trade surplus. While, at the same time encouraging consumers to begin saving. This is significant because since Japan switched to such a policy, they have greater control over the economy. As the country, was able to continue to see high amounts of savings rates and trade surpluses, which are used to invest in other areas around the world. (12 Myths of International Trade, 1999)

The biggest drawback of the floating exchange rate policy is: it allows the country's currency to be subject to extreme amounts of fear and greed. This is because the currency markets are constantly facing large amounts of emotionalism. Where, the slightest piece of news can cause: investors, traders and speculators to believe the best or worst case scenario is occurring. When the currency is floating up or down, they will often look at other outside information to have an indication as to if the overall up or down trend will remain in place. At certain times, these amounts can become so extreme, that the central bank is forced to reduce the overall money supply in an attempt to address this issue. This would normally occur, when the currency has remained strong for large amounts of time. An example of when the central bank would be reducing the available supply of money can be seen in the U.S. dollar from 1995 to 2000. During this time, the demand for dollar based assets would rise dramatically, as the investors, traders and speculators wanted to own American based assets at any cost. This was a reflection of the above average growth that the economy was experiencing at the time. The problem began with the belief that economic growth was going to continue for some time, developing a bubble in dollar based assets. To deflate this bubble, the Federal Reserve would raise interest rates and would restrict the amount of money that was released to the financial system. This would cause the dollar to begin an inevitable decline that would become more severe within the next several years. (Rise of the Dollar, 2005)