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"To fix or not to fix?"

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Introduction

"To fix or not to fix?" is a long-standing question in macroeconomics. The issue that sounds deceptively simple has led some countries to face dire consequences by virtue of making a bad choice. The choice of exchange rate regime involves considerations that extend beyond merely the stability of currency prices. This paper juxtaposes the relative merits and demerits of both the regimes and by critically evaluating them leads to the conclusion that no one regime is better than the other. The optimal choice of the regime is relative, depending on various underlying conditions of the economy. It has been observed in the past that attempts to defend a fixed exchange rate has translated into extremely costly financial crises e.g. 11 percent fall in Thai GDP in 1998, the Korean crisis in 1997, and Russian crisis in 1998 (Williamson, 2004). The policy measure that governments of overvalued currency resort to is devaluation, but the gains from devaluation take time to materialize while the negative effects set in immediately1 and this often results in a recession. On the other side, there are similar costs of defending an undervalued exchange rate which accrue in the form of inflationary pressures. ...read more.

Middle

Indeed the rationale of a fixed exchange rate system essentially precludes the conduct of an independent monetary policy. The fixed exchange rate regime answers to this situation is based on the premise of "importing credibility", which it achieves by to this committing themselves overtly to imitate the monetary policy of the more competent central banks. But the logic of the argument is far from convincing are weak because it irrationally places a greater confidence in (indirect) exchange rate targeting (Kenen, 2000). Furthermore one rather political argument against the fixed exchange rate regime is that it would mean the domestic economy would be loosing a great deal of democracy as foreigners (the anchor) would be controlling our money. Moreover, in fixed rate regimes, monetary policy must be subordinated by fiscal policy in order to maintain the exchange rate fixed, this effectively ties the hands of the authorities. (Caramazza and Aziz, 1998) Addressing the same task of economic stimulation via fiscal policy would result in government increasing its budget deficit. The associated upward pressure on interest rates induces an appreciation of the dollar, which in turn discourages exports, encourages imports, and reduces net capital inflow. ...read more.

Conclusion

A conventional view is that a fixed exchange rate has the advantage of sharply reducing or eliminating exchange rate volatility, this element of certainty will (relatively) reduce transaction costs associated with hedging currency risk. It is also worth mentioning some countries which have less developed financial sectors are ill-equipped with tools to hedge such risks. This certainty coupled with reduced transaction costs will in turn bolster trade across borders. The flip side of this certainty means inviting speculative attacks (Napolitano and Canale, 2002) as was the case with sterling in autumn 1992, the market perceived it to be overvalued and an impending devaluation was expected. .Under Fixed exchange rate regimes where interest rates are higher than the anchor country, there is an incentive to borrow unhedged in the anchor currency, pressurizing local currency to loose value. To withstand such pressures under fixed exchange rate regimes, authorities impose capital controls. All in all, a country cannot maintain a fixed exchange rate, open capital market, and monetary policy independence at the same time. Based on the already established arguments and we acknowledge that there is no universally "optimal" regime. Both the regimes have their strengths and weaknesses and the best regime is the one that minimizes the fluctuation in output and prices, moreover one that stabilizes macroeconomic performance. ...read more.

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