Saturday, 17 December 2016

Floating Rate Mechanisk & Fixed Rate Mechanism

In the  floating  rate mechanism,  the  exchange  rate  is  determined  by  the market  forces, while  in  fixed  rate  mechanism,  the  exchange  rate  is  determined  by  the  government. Therefore, in floating rate mechanism, the exchange rate depends on the perception of the market about the relative worth of various currencies while  in the fixed rate mechanism, the rate depends on what the government wants it to be.

      In fixed  rate mechanism,  the government needs  large amounts of  reserves  to be able  to maintain  the  currency  at  the  level  it wants.   In  the  floating  rate  system,  the government does not interfere in the market.

 In some  variations  of  the  fixed  rate mechanism,  the  value  of  the  currency  is  adjusted upwards or downwards depending on the values of certain key parameters such as money supply. The fixed rate system though useful for maintaining a stable exchange rate, may give rise to market distortions  in  the  long  run.  
    The  floating  rate  system, on  the other hand, may result in wide fluctuations in the exchange rates over short time intervals but is expected to settle down at its true value.

Many experts favor the flexible exchange rate mechanism on the following arguments:
  • Better adjustment
  • Better confidence
  • Better liquidity
  • Gains from freer trade
  • Increased independence of policy

Better adjustment: One of the most  important arguments  for flexible exchange rates  is that  they provide a  less painful adjustment mechanism to trade imbalances than do fixed exchange rates. For example, an incipient deficit with flexible exchange rates will merely cause  a  decline  in  the  foreign  exchange  value  of  the  currency,  rather  than  requiring  a recession to reduce income or prices as fixed exchange rates would. It should be clear that a  decline  in  the  value  of  a  currency  via  flexible  exchange  rates  is  an  alternative  to  a relative  decline  in  local-currency  wages  and  prices  to  correct  payments  deficits.  The preference for flexible exchange rates on the grounds of better adjustment is based on the potential for averting adverse worker reaction by only indirectly reducing real wages.

Better confidence:  It  is  claimed  as  a  corollary  to  better  adjustment  that  if  flexible exchange rates prevent a country from having  large persistent deficits, then  there will be more confidence  in  the  country and  the  international  financial  system. More confidence means fewer attempts by  individuals or central banks  to readjust currency portfolios and this gives rise to stable forex markets.

Better liquidity:  Flexible  exchange  rates  do  not  require  central  banks  to  hold  foreign exchange reserves since there is no need to intervene in the foreign exchange market. This means  that  the problem  of  insufficient  liquidity does not  exist with  truly  flexible  rates, and competitive devaluations aimed at securing a larger share of an inadequate total stock of reserves will not take place.

Gains from  freer  trade: When  deficits  occur  with  fixed  exchange  rates,  tariffs  and restrictions on  the  free  flow of goods and capital  invariably abounds.  If, by maintaining external balance,  flexible  rates avoid  the need  for  these  regulations, which are costly  to enforce, then the gains from trade and international investment can be enjoyed.

Increased independence  of  policy:  Maintaining  a  fixed  exchange  rate  can  force  a country to follow the same economic policy as its major trading partners. For example, if the United States  allows  a  rapid growth  in  the money  supply,  this will  tend  to push up U.S.  prices  and  lower  interest  rates  in  the  short  run,  the  former  causing  a  deficit  or deterioration in the current account and the latter causing it in the capital account.

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