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Advantages and Disadvantages of High and Low Exchange Rates & of a Fixed and Floating Exchange Rate System

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Introduction

Eva Lamadé October 2012 IB Economics Hall Advantages and Disadvantages of High and Low Exchange Rates & of a Fixed and Floating Exchange Rate System 1. An exchange rate is the price of one currency expressed in terms of another. If the U.S. exchange rate for the Canadian Dollar is $1.60, this means that 1 American Dollar can be exchanged for 1.6 Canadian dollars. With a high exchange rate, there are many advantages: Imports become relatively cheaper. For example the price for imported raw materials becomes cheaper; the cost of production for firms becomes less. This could lead to decreased prices for consumers. The lower price of imported goods also puts pressure on domestic firms to keep prices low. All this leads to a downward pressure of inflation. Furthermore, more imports can be bought. A high exchange rate means that for each unit of the currency, more units in foreign currencies can be bought. Therefore there will be more visible imports, such as technology, and invisible imports, such as foreign travel. Moreover, a high value of currency forces domestic producers to more efficiency as they will try to remain their competitiveness. This would lead to greater economic productivity of the country. ...read more.

Middle

Usually the central bank or government decide upon and maintain the value of the currency. Price of B$ in US$ S1 S2 D1 D2 Q1 Q2 Quantity of B$ The Barbadian Dollar has been fixed against the US dollar at a rate of 2Bds$ = 1 US$ since 1975. When there is an increase in supply, defined as the willingness and ability of products to produce a quantity of a good at a given price in a given time period, for Barbadian dollar, for example due to the Barbadians purchasing a greater amount of imports, the supply curve shifts from S1 to S2. There is excess supply of Barbadian dollars from Q2 ? Q1. Without intervention by the government, the exchange rate would fall, leading to inflationary problems. The government will then buy up the excess supply of its own currency on the foreign exchange market. This shifts the demand curve from D1 to D2. This is possible due to previously amassed reserves of foreign currencies. An advantage of such a fixed exchange system is the reduction of uncertainties for all the economic agents in the country. Firms will be able to plan ahead, knowing that the predicted costs and prices for international trading agreements will not change. ...read more.

Conclusion

To keep the current account balanced, the floating exchange rate should adjust itself. For example a current account deficit, the demand for the currency is to low since export sales are relatively low. The supply of the currency is high, since the demand for imports is relatively high. As you can see, markets adjust and the exchange rate should fall. Export prices become relatively attractive, import prices relatively less attractive and the current account balance should settle itself. Another advantage is that reserves are not used to control the value of the currency. This makes is unnecessary to keep high levels of foreign currencies and gold. There are also disadvantages. Uncertainty tends to be created. Planning of businesses tends to be difficult and investments, defined as the expenditure by firms on capital equipment and is an injection into the economy, are hard to assess. The levels of international investment will decrease. Furthermore, in reality, floating exchange rates are affected by many factors, not only demand and supply. Another factor would be speculation. Therefore they might not adjust themselves and might not eliminate current account deficits. Last, a floating exchange rate regime may worsen existing levels of inflation. High inflation relative to other countries will make its exports less competitive and imports will be relatively less expensive. Yet, this could lead to even higher prices on import goods and services and inflation. ...read more.

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