Exchange Rate Systems and The Cost and Benefit of Each Exchange Rate System for The Economy as a Whole
This article discuss briefly different Excahnge rate regimes. In addition, it discuss the cost and benefit of each system. As well, it highlights the viability of floating exchange rate system in the context of compleixity and unpredictable economic shocks and the responsiveness of price mechanism and its benefits.
Monetary Union
The aim of monetary union is to promote trade and achieve low inflation compared to a low inflation country in the union. However interest rates have to be set at a level consistent at keeping the currency value at a certain level. The problem with this system is that if the economy is weak and interest rate will be higher than other wise and increase domestic instability. In addition, the currency may loose value and the speculators may attack the currency.
The cost and benefit of Fixed exchange rate system
Any country can have two out of three exchange rate systems. An independent monetary policy, fixed exchange rate system, open capital account. However due to international financial markets countries have move towards a flexible or floating exchange rate system where the price mechanism supported by credible monetary policy to respond to complex and unpredictable shocks.
The case for fixed exchange rate system is stability of the value of currency which enables trade and capital investment. In addition, the cost of hedging the currency is reduced It also encourages the domestic producers to lower cost and prices down and improve productivity.
The cost of fixed exchange rate is increased currency speculation and less freedom in domestic monetary policy. As well, the country must have high level of currency reserves to intervene in the market to set target rates. As well currency stability may achieved at a cost of domestic stability.
The cost and benefit of floating exchange rate system
The benefit of floating exchange rate system is that it need not have high level of currency reserves to intervene in the market. In addition, there is less speculation and to have a more independent monetary policy. As well, the currency may enable to increase aggregate demand and there fore internal stability. Floating exchange rate also provides partial correction of trade deficit. In practice floating exchange rates are not that volatile. However it can be volatile in some circumstances.
The cost of floating exchange rate is that the differing rates may increase risks and there fore hedging costs. In addition floating exchange rate may not encourage local producers to lower cost and pricing as well improvement in productivity. Another cost of floating exchange rate is that it do not reflect comparative advantage like fixed exchange rate system.
Summary
As mentioned above all countries do not have the same exchange rate system. However, most of the countries are moving in the direction to have a floating exchange rate system. All exchange rate system as discussed have cost and benefits. However, on the balance given the international financial markets the fixed exchange rate system is not feasible compared to floating rate system.
In addition, it seems as discussed above the floating rate system is more beneficial than the fixed exchange rate system ina developed international final market conditions.
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