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In the light of recent British economic experience, critically assess the view that allowing the pound to float is better for Britain than having a fixed exchange rate.

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Introduction

In the light of recent British economic experience, critically assess the view that allowing the pound to float is better for Britain than having a fixed exchange rate. The UK government can choose to 'fix' or 'float' the exchange rate. But what do these terms mean? Which method is 'better' than the other? By defining what fixed and floating exchange rate systems are, and by using the recent experiences of the British economy, it is possible to shed a little light on the issues surrounding the control of exchange rates. A floating exchange rate system is a system of supply and demand for pounds. If, for example, the UK is in deficit due to excess imports from a particular country, then the pound should depreciate against the currency of that country. This happens because UK importers sell extra pounds on the foreign exchange markets in order to buy the other country's currency to pay for those imports. Now there is an excess supply of pounds which lowers the sterling exchange rate. So, provided that the Marshall-Lerner elasticity conditions are fulfilled, the lower price of exports and the higher price of imports will, over time, improve the UK balance of payments.1 The system should therefore regulate itself making it sustainable and leaving no pressure on reserves. A fixed exchange rate can take different forms. One is an adjustable peg system where the currency is pegged to another currency, but can be adjusted in small movements if necessary. ...read more.

Middle

The opportunity for large scale speculation may be reduced as rates are allowed to move up and down without restriction. This in turn means that a country has less need for reserves. The disadvantages of a floating exchange rate are: an increased uncertainty for traders which may lead to less investment; the threat of price instability through increasing import prices; and, a floating exchange rate may actually encourage speculation through co-ordinated buying and selling of sterling. The recent economic performance of the UK can be used to can evaluate the effect of a fixed or floating exchange rate as both methods have been used. Between 1990-1992, the UK entered into the exchange rate mechanism (ERM) which fixed the sterling against other Euro currencies. Unemployment rates, GDP levels and export volumes can all be used as indicators of the UK's economic performance during this period. Below is a table which shows indices for export volumes, unemployment rates and the average exchange rate against sterling during the period of 1979-2000. Table 1. Export, Unemployment and Exchange Rate Indices 1979-2000 1990=100 Year Exports Unemployment rates Average rates against sterling 79 89.4 98.9 113.1 80 90.5 100.1 124.4 81 91.6 102.8 127.8 82 92.7 103.6 123.3 83 93.8 104.3 115.6 84 94.9 105.0 111.4 85 96.0 104.4 111.3 86 95.1 104.4 101.4 87 96.8 103.9 99.3 88 97.8 101.9 105.3 89 98.9 100.4 102.3 90 100.0 100.0 100 91 101.5 101.5 100.7 92 102.6 102.9 96.9 93 103.7 103.6 88.9 94 104.8 102.9 89.2 95 105.9 101.9 84.8 96 107.0 101.4 86.3 97 108.0 100.3 ...read more.

Conclusion

Another reason why export volumes may have decreased, could be due to an increase in domestic prices which is a sign of a growing economy. So it could be argued that the whilst the Lawson boom increased the wealth of the economy, at the same time it had a negative effect on the level of UK exports. There is certainly some evidence then that being attached to a fixed currency can have a negative effect on unemployment, export volumes and GDP. This evidence though, is inconclusive as the data from the key period is clouded by another historic economic event, the Lawson Boom. Patrick Minford argues that, fixed exchange rates can work given a number of characteristics within the monetary environment. These characteristics are: symmetric industries, automatic stabilisers, freedom of movement of labour and flexible wages.9 However, these conditions are not met within the Euro zone. There are advantages in belonging to a fixed exchange rate system but currently the disadvantages leave a serious doubt over whether it is the 'better' option. The sacrifice of monetary and fiscal policy must be compensated for with significant gains in economic security. There are doubts as to whether a fixed exchange rate system is better than a floating system. If a fixed rate system is joined, then it is imperative that it is joined at the right rate or the problems of the ERM will re-surface and Britain may suffer for many years to come. Even if it is joined at the right rate, over a lengthy period of time that 'correct' rate is likely to change. ...read more.

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