A fixed exchange rate regime gives firms the stability they need to manage their cash flows
Exchange Rate Regime:
The exchange rate regime is the way a country manages its currency in respect to foreign currencies and the foreign exchange market.
Types of Exchange Rate Regime:
The basic types of exchange rate regime are:
Float: In floating exchange rate market dictates the movements of the exchange rate.
Pegged float: In pegged float central bank keeps the rate from deviating too far from a target band or value.
Dollarization: Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency.
Fixed: The fixed exchange rate ties the currency to another currency, mostly more widespread currencies such as the U.S. dollar or the euro.
Fixed Exchange rate:
A fixed exchange rate policy is wellâ€understood by bankers, practitioners, and academics
around the world. It occurs when a currency is kept at a certain level compared to other currencies. In practise many of them are semi fixed exchange rates like the ERM (Exchange Rate Mechanism).
Advantages of Fixed Exchange Rate
There are a variety of advantages to fixed exchange rates:
One of the most important advantages of fixed exchange rates is that it helps in the future planning of the amount of investment and the amount of business that a company can undertake. With a fixed rate, the company does not risk loosing too much money as it reduces the speculation in the exchange.
Another benefit of having a fixed exchange rate is that it helps traders of various kinds of goods to fix up a steady rate and thus reduce the risk in investment. This encourages the traders to invest in the market.
Also a fixed exchange rate enables the government to exempt themselves from following the inflammation policies and thereby sustaining the competition in the market. This takes care of various problems that are associated with the balance of payments.
A fixed exchange rate moreover, reduces speculation which is a vital risk in running a stable market. Reduction in speculation does away the risk of destabilizing the economy.
So these are the various benefits that a fixed exchange rate in the market achieves but like all the things there is another side to the coin in having a fixed rate. This includes a huge amount of investment that is required to keep upto the market rate and the loss of freedom in deciding the integral policies.
The Conditions for a Fixed Exchange Rate
The combination of events and analysis have also created a good understanding of the
conditions that need to be satisfied in order for a fixed exchange rate to make sense.
Some years ago I in fact laid out what I saw as the essential conditions for it to be
sensible to fix the exchange rate-firmly fixing it for "ever", not temporarily fixing it
until some shock makes the politicians decide that it would be advantageous to change
(Williamson 1991). I quote what I then wrote:
1. The economy is small and open, so that it satisfies the conditions for being
absorbed in a larger currency area according to the traditional literature on
optimum currency areas.
2. The bulk of its trade is undertaken with the trading partner(s) to whose currency
(or whose mutually-pegged currencies) it plans to peg. This is necessary if
stability of the bilateral exchange rate is to secure a reasonable measure of
stability of the effective exchange rate that is essential for macroeconomic
stability. What is meant by "the bulk of its trade"? I would settle for a 50 percent
threshold as a working figure, because 60 percent seems more than enough and 40
percent seems too little.
3. The country wishes to pursue a macroeconomic policy that will result in an
inflation rate consistent with that in the country (or countries) to whose currency
(or currencies) it plans to peg. This policy will be sensible if the center currency
provides a stable anchor and the domestic economy is capable of living
comfortably with price stability. Conversely, it will be foolish if the center
country suffers rapid inflation or the domestic price level has a life of its own,
either because fiscal indiscipline entails reliance on the inflation tax
2
or because
cost-inflationary pressures are entrenched.
4. The country is prepared to adopt institutional arrangements that will assure
continued credibility of the fixed rate commitment. This may best be established by replacement of a central bank, having the ability to finance fiscal deficits, with
a currency board. Alternatively, an independent central bank committed to the
fixed rate (for example, that of Austria
3
), or participation in an international
agreement that has established credibility such as the European Monetary System,
may suffice… A common currency, of course, will guarantee total credibility.
http://www.iie.com/publications/papers/williamson0904.pdf
Criticisms
The main criticism of a fixed exchange rate is that flexible exchange rates serve to automatically adjust thebalance of trade.[5] When a trade deficit occurs, there will be increased demand for the foreign (rather than domestic) currency which will push up the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, this automatic rebalancing does not occur.
Governments also have to invest many resources in getting the foreign reserves to pile up in order to defend the pegged exchange rate. Moreover a government, when having a fixed rather than dynamic exchange rate, cannot use monetary or fiscal policies with a free hand. For instance, by using reflationary tools to set the economy rolling (by decreasing taxes and injecting more money in the market), the government risks running into a trade deficit. This might occur as the purchasing power of a common household increases along with inflation, thus making imports relatively cheaper.
Additionally, the stubbornness of a government in defending a fixed exchange rate when in a trade deficit will force it to use deflationary measures (increased taxation and reduced availability of money) which can lead to unemployment. Finally, other countries with a fixed exchange rate can also retaliate in response to a certain country using the currency of theirs in defending their exchange rate.
[edit]Fixed exchange rate regime versus capital control
The belief that the fixed exchange rate regime brings with it stability is only partly true, since speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control. A fixed exchange rate regime should be viewed as a tool in capital control.
For instance, China has allowed free exchange for current account transactions since December 1, 1996. Of more than 40 categories of capital account, about 20 of them are convertible. These convertible accounts are mainly related to foreign direct investment. Because of capital control, even the renminbi is not under the managed floating exchange rate regime, but free to float, and so it is somewhat unnecessary for foreigners to purchase renminbi.
http://en.wikipedia.org/wiki/Exchange_rate_regime
http://www.currencytrading4beginner.com "List Four Advantages Of Fixed Exchange Rates"
