Alternative Exchange Rate Regimes

Alternative Exchange Rate Regimes

Jacquelin Chavis

Argosy University

International Finance Management

BUS 434

November 8, 2015

Alternative Exchange Rate Regimes

A country's exchange rate regime is the practice used by the government or central bank to tie the official exchange rate to another country's currency.  The flexible or floating exchange rate system acts as an automatic stabilizer.  It fluctuates up and down and what the rate will be shortly is hard to predict.  It is necessary to maintain an internal and external balance under a system that recognizes coins as legal tender.  The coin standard leads to a fixed exchange rate system.  Unlike the fixed rate regime, if unemployment and other variables change the exchange rate changes.  The flexible exchange rate allows for a change in the appropriate direction depending on the changes in variables that affect the exchange rate ("Econ," n.d.).  

When global exports demand decline the country’s currency depreciates.  Depreciation makes the country’s good cheaper and more appealing to outsiders.  The flexible exchange rate system allows countries to put in place monetary policies to address problems with inflation and output.  Monetary policies have a direct effect on a countries inflation rate; the flexible rate allows countries to decide on their average inflation rate.  They are not required to take on another countries inflation rate.  The primary disadvantage of the flexible exchange rate system is its unpredictability.  The use of too much autonomous policy authority has the potential to create higher inflation rates.  Flexible exchange rates may not frequently change enough to eliminate current account imbalances ("Econ," n.d.).

The purpose of a fixed exchange rate system is to maintain a country's currency value within a very narrow range.  Fixed rates are not supposed to change; they are meant to remain permanently.  Fixed rates provide greater certainty for exporters and importers.  Fixed rates help the government maintain low inflation, which, in the long run, should keep interest rates down and stimulate increased trade and investment.  The fixed exchange rate helps to avoid currency fluctuations.  If the value of currencies fluctuates significantly, this can cause problems for firms engaged in trade.  If a firm relied on imported raw materials devaluation would increase the costs of imports and would reduce profitability.  If a firm were exporting to the US, a rapid appreciation of sterling would make its exports uncompetitive and, therefore, may go out of business ("Dummies).  

A stable exchange rate encourages investment.  The uncertainty of exchange rate fluctuations can reduce the incentive for firms to invest in export capacity.  The uncertainty of exchange rate fluctuations can reduce the incentive for firms to invest in export capacity.  A rapid increase in value in the exchange rate will badly affect manufacturing firms who export.  Although there are many advantages to the flexible exchange rate system there are also some disadvantages.  For example, to maintain a fixed level of the exchange rate may conflict with other large-scale economic objectives.  When firms are entering the market, they should strive to enter at the rate that is not too high or too low.  An exchange rate that is too high will affect export competitiveness and an exchange rate too low could cause inflation.  If a currency is falling below its band, the government will have to intervene.