A country’s current account on the balance of payments may move into disequilibrium. Different exchange rate systems have different ways of returning the balance of payments back into equilibrium. The movement back often involves economic costs, such as increased unemployment, which can occurred under the Gold Standard System or lower economic growth, under the Bretton Woods System, both of which are examples of the fixed exchange rate system (a rate of exchange between at least two countries, which is constant over a period of time).
Freely floating exchange rates offer greater flexibility of trade, than other exchange rate systems. It is possible for UK exports to remain competitive abroad during a period of domestic inflation. The purchasing power parity theory states that in the long term, exchange rates will change in line with the different inflation rates between countries. For example, assume that the balance of payments of the UK is in equilibrium, so that the value of exports equals the value of imports and capital outflows equals capital inflows; but there is a 5% inflation rate, i.e. the prices of goods in the UK rises by 5% annually. Also assume that there is no inflation in the rest of the world. This means that the average price of UK exports will rise in comparison to competing economies, therefore, UK exports will become less price competitive and their sales will fall. However, UK imports will become cheaper than domestically produced goods, therefore becoming more price competitive and their sales in the UK will rise. The current account on the balance of payments will subsequently move into a deficit. A fall in the volume of exports will lead to a fall in the value of UK exports, assuming that they are price elastic in demand and the demand for pounds will fall. On the other hand, UK imports sill result in a rise in the supply of pounds. Therefore, a fall in demand and a rise in supply of pounds will result in a fall in its value, so that eventually in the long run, the exchange rate will change in line with changes in prices between countries.
b) Evaluate the case for UK membership of a fixed exchange rate system in the global economy (50 marks)
A fixed exchange rate system is a rate of exchange between at least two countries, which is constant over a period of time. The UK has been a member of a fixed exchange rate system and is the best known example of the system, the Gold Standard Agreement, up to 1910, then between 1918 and 1931. Under the Gold Standard, the major trading nations made their domestic currencies convertible into gold at a fixed exchange rate. The domestic money supply was directly related to the amount of gold held by the central bank. Another type of the fixed exchange rate system, of which is in current existence, however the UK is not a member of is a common currency agreement, called the European monetary Union (EMU). Although, they both share many advantages and disadvantages in common, each system also has costs and benefits associated with their period and circumstances of existence.
Economies often have fixed exchange rates to overcome the disadvantages of a freely floating exchange rate system. For example, a disadvantage of the freely floating exchange rate system was that there was uncertainty in regards to trade. Speculation occurs and currencies may be bought on the spot or in advance (Forward). A fixed exchange rate system’s features include confidence, stability and certainty in trade, as the rates are fixed and therefore predictable. However, there are high operation costs involved. For example, pressure is put on the gold (in the case of the Gold Standard) and the foreign currency reserves at the central bank, which in the UK is the Bank of England. Under the Gold Standard Agreement, the Bank of England had a domestic obligation to convert money into gold. A fall of gold reserves at the Bank of England also meant an equivalent fall in the paper money circulation in the UK. Although it is expected that it is the central bank must correct imbalances, it does not seem entirely possible, especially if one takes the example of Black Wednesday. This is a date in UK history where relying just one the central bank was not enough, it would take a concerted and co-ordinated action by groups of central banks to make a correction.
The Gold Standard Agreement, in theory, argues that gold transfers between deficit and surplus countries would settle international indebtedness arising from balance of payments deficits. For example, if country A was in surplus and country B in deficit, the gold reserves in A would rise, whereas they are falling in B. Country A to preserve the ratio of gold to money supply, its central bank should increase the money supply, causing the aggregate demand curve to move to the right and inflation to occur, making exports less price competitive and imports from country B more competitive. On the other hand, in country B, to sustain the ratio between gold and the money supply, its central bank must reduce the money supply, causing aggregate demand to fall, other things remaining equal, leading to deflation. Hence, country B’s exports become more price competitive (assuming that the goods are price elastic) and its imports less price competitive. Although the system is supposed to work automatically to achieve equilibrium, in practice this did not work. The surplus countries did not expand their domestic money supply, resulting in the deficit countries having to deflate their economies even more. The system also assumed that as aggregate demand fell in the deficit countries, employment would remain high, because wages would fall. However, this did not happen and deficit countries recorded high levels of unemployment. Either a devaluation agreement or a domestic deflationary policy must correct balance of payments disequilibrium, but usually both are used. Long-term deficit countries tend to suffer from deflationary forces, which results from the deficit.
If the UK were to enter a fixed exchange rate system, the rate would be limited in flexibility for adjustment. For example, the ERM (although an example of a managed exchange rate system) the UK exchange rate was limited in being 2¼% or 6% either side of the parity. Also, this creates some certainty, as one knows it will not exceed 6% but there is still uncertainty in its leeway of the 6%. Domestic adjustments for GDP by use of fiscal and monetary policies would have to be consistent with the fixed exchange rate, as the exchange rate has significant impacts on domestic inflation, employment and output.
If the UK were to join a fixed rate exchange system, such as the European Monetary Union (EMU), a single currency would be in place between the countries. The transition costs of such a procedure are costly, but even more so if the EMU ceases to function. There would be a loss of independence surrounding fiscal and monetary decisions however there will be no exchange rate costs between member countries. Although, it would be advantageous for the UK to join the EMU on the basis that UK business are more open to a wider base of consumers, a loss of independence for such an important financial base may be costly.
