Fixed Exchange Rate System example essay topic

Inflation Rates By: Anonymous The price of one currency in terms of another is called the exchange rate. The exchange rate affects the economy in our daily lives because it affects the price of domestically produced goods sold abroad and the cost of foreign goods bought domestically. "Mexicans use pesos, French use francs, Austrians use schillings, and this use of different monies by different countries results in the need to exchange one money for another to facilitate trade between countries" (Husted 315). Without the exchange rate it would make it impossible to purchase goods in other countries that have a different currency.

Day-to-day movements in exchange rates are closely related to people's expectations. "The role of monetary policy would be to manage the exchange rate. A monetary expansion would tend to lower interest rates, thus lead to short-term funds flowing into foreign currencies, and so depreciate the domestic currency" (Corden 21). Throughout the history of the economy, the exchange rate has not always been controlled under the same monetary system. Foreign exchange is usually traded as bank accounts denominated in different currencies. Most of the trade takes place between the major banks and between banks and their corporate customers.

Modern communications make it a truly global market. The rates vary by minute. "Exchange rates changes are largely unexpected and so there is an important element of risk in multinational transactions that domestic transactions lack" (Husted 320). The closing rates in each financial center are reported regularly in the media. The closing rates of the previous day are listed in the morning newspaper for leisurely reading. There are two main types of foreign exchange systems: 1) fixed exchange rate, and 2) floating exchange rate.

A fixed exchange rate system is where governments can set a certain fixed rate at which their currencies will exchange for each other and then commit themselves to maintaining this rate. Countries use an agreed-upon currency worth a specific measure standard. On the other hand, the unregulated forces of supply and demand determine the floating exchange rate system. "During this, there is a trade-off between the rate of inflation and the current account" (Corden 86).

"If a country imports large quantities or goods, the demand will push up the exports imports large quantities of good, the demand will push up the exchange rate for that country, making the imported goods more expensive to buyers in that country. As the goods become more expensive, demand drops, and that country's money becomes cheaper in relation to other countries' money" (Gwinn 627). From 1870 to 1914, the exchange rate was determined by the Gold Standard. This system was a fixed exchange rate, and the way it worked was by pricing every currency in terms of gold.

So in general terms, if X amount of one currency was equal to one ounce of gold, and Y amount of currency was also equal to one ounce of gold, then X and Y can also be exchanged. But this system had many flaws that led to a new system after all those years. The main problem with the gold standard arose due to the fact that the money supplied depended a great deal on the amount of gold held in banks, but the countries had little control over the money supply. If the demand for a currency exceeded the actual supply, banks were forced to ship gold to satisfy the individual country's requirements for the scarce currency.

A flow of gold into a country obviously increased the money supply, which in turn raised prices and made its goods more expensive. This, in turn, reduced foreign demand for its currency. Then an example of how this relates to exchange rates is that if the total demand for a certain currency is decreased, the value of the currency also decrease. So more of it has to be exchanged for another currency to be equal in value. So because of this problem, the gold standard was replaced by a new monetary system.

This new system was established near the end of World War II, and it was called the Bretton Woods system. "The experts who had negotiated the Bretton Woods Agreement, and the Governments that had endorsed it, had been inspired by a desire to learn from lessons of inter-war experience and to prevent its recurrence after the removal of war-time exchange control" (Einzig 12). "The system that had promised to prolong war-time stability of exchange rates was welcomed with open arms by most people" (Einzig 13). This system was also like a fixed exchange rate system because it established rules that stated that each country agreed not to alter the exchange value of their currencies beyond certain limits without prior consent. As a result, of the Bretton Woods system did not turn out to be what was planned; instead of promoting a growth it had a negative affect on international trade. Governments both will not and cannot stick to pegged or fixed rates.

First, maintaining targeted or fixed rates requires a consistent and fairly uniform monetary policy among nations. There are many reasons that national governments will not consent to this, the most important reason is that different countries want different things, different economies have different needs and different governments have different policies. There are other problems with fixed rates. Even if the system could be maintained, the economies in the rest of the world probably are not integrated enough to deal with a fixed rates system and correct imbalances of trade. Money is free to flow from county to county, but labor is not and neither are many businesses.

So in the 1970's the Bretton Woods system and the fixed exchange rate system gave way to a floating rate system, where, as mentioned before, the rates are largely determined by supply and demand in international currency markets. It was in 1971 that the United States replace the gold standard completely because the United States refused to convert dollars, held by foreign central banks, into gold anymore and the U.S. tried maintaining the dollar at a fixed exchange rate with other currencies instead of gold. But this still was not a good system. Then by 1973 the Bretton Woods system was no longer in effect either, and the change to the floating exchange rate system was complete. "Since March 1973, there has been five main currencies, they make up a managed floating non-system.

Each country has been completely free to conduct its monetary policy as it wished, and flexible exchange rates could accommodate differential inflation rates" (Corden 179). Since then, all major industrial countries have followed the U.S. and allowed their currencies to "float" also. So each country has the freedom to find their own values in relation to other currencies to set their own exchange rates, but the central banks still have the authority to intervene occasionally to prevent large short-term fluctuations in the exchange rates. There are, at least, some advantages to freely floating rates. They can act as "shock absorbers". The biggest advantage of floating exchange rates is that they give each country control over its domestic affairs.

Some economist's favor floating rates for many of the same reasons that they favor a free market system; these people believe that currency prices should be determined by supply and demand, and not just by government regulation. On the other hand, there are bankers and international traders that tend to prefer fixed exchange rates because they are much more reliable for doing business. If there are floating exchange rates there may be large fluctuations in a very short period of time that could possibly result in a recession or inflation in their country. "Exchange rate changes that deviate from their equilibrium values lead to adjustment problems and real effects on the economy. Econometric studies of impact of foreign exchange rate variation on foreign direct investment typically focus on the short-term variability of exchange rates" (Hasn at 235). One can see the effects of the exchange rate on other aspects of the economy if you examine it closely.

One major impact the exchange rates have on the economy deals with imports and exports. Exchange rates tell how much one currency is worth in terms of another, so for an example to compare the effect on imports and exports to domestically produced goods, we can examine a situation with the Japanese yen and the U.S. dollar. The higher the cost of a yen in terms of dollars also means the lower the cost of dollars per yen. The result is the Japanese would much rather buy American goods because they can get more in terms of an American dollar.

Also, the American demand for Japanese goods will be lower since Americans can get more value out of their own currency when purchasing American goods. Demand and supply with international trade is also affected greatly by the exchange rates. Americans who want to buy, for example, Japanese goods, which would be Japanese exports and American imports, demand yen. The lower the price of yen, and therefore the lower the exchange rate between the yen and dollars will make it cheaper to purchase Japanese goods with dollars.

So there will be a higher demand for yen in this case because Americans will exchange their dollars for yen, and then buy the Japanese goods. As for the supply of yen, the Japanese who buy U.S. goods, which would be U.S. exports and Japanese imports, would supply the yen with these purchases. To help determine this quantity supplied, Japanese would supply more yen if the price of the yen was high or the value of the dollar was low because they will be more willing to buy American goods in this case. Another factor in the economy affected by the exchange rates is the price level of goods. The lower the value of a certain currency in a country, the higher the prices eventually become in that country. This is because as the value of the U.S. dollar lowers, more American goods are demanded, and this makes the price increase because aggregate expenditures go up.

While different factors in the economy are affected by the exchange rates, the exchange rates are also affected by some other factors in the economy. An important influence on the exchange rates is interest rates. If the interest rates are higher in Japan than in the United States, more people will want to invest in Japanese securities. So Americans will exchange their dollars for yen, which increases the demand for yen.

Then these newly acquired yen from the exchange of the U.S. dollars are used to buy the Japanese securities. This increase in demand of yen will eventually cause an increase in the price of yen and also a decrease in the value of the dollar. When the price of the yen rises it takes more dollars to buy Japanese goods, and the exchange rate will consequently rise. Currently, the exchange rate system is still a floating one, which is obvious by the daily changes in all of the exchange rates similar to this dollar / yen example. But presently there is a little more control over the exchange rates from the central banks of the respective countries to prevent the major fluctuations that many citizens' fear and to keep the economy as stable as possible.

The following data was received from FRED. It submits data on the exchange rates between Australia, Canada, Mexico, Britain, and France all compared to 1 U.S. dollar. The first column is a comparison of exchange rates to the U.S. dollar to Australia. The next column is the Canadian dollar to the U.S. dollar, and the last column is a comparison of the Mexican peso to the U.S. dollar. In the last chart, compares in the first column, the exchange rate between the U.S. dollar to the British pound.

Finally, in the last column, relates the French francs to the U.S. dollar. World trade now depends on managed floating exchange system. Governments act to stabilize their countries' exchange rates by limiting imports, stimulating exports, or devaluating currencies. Floating exchange rates are the best system available to central banks at this time. This system is certainly not without flaws, but it is the only feasible choice.

Governments will always desert a fixed rate system, either when their reserves run out or when domestic inflation or recession becomes too severe..