However, for most of the days, the currency remains stable. As a result, exports are encouraged, and imports are discouraged thereby, establishing equilibrium in the balance of payment. Hence, if there is likelihood that the monetary policy may be misused for personal gains by a group of influential people, then it is better to peg the currency to another more developed currency. It allows you to determine how much of one currency you can trade for another. A weak home currency tends to increase a country's exports and decrease its imports, thereby lowering its unemployment.
The main way of doing this is through the manipulation of interest rates. The decision helped the Chinese economy to emerge two years later relatively unscathed. Therefore, the gap between the underlying fundamentals and the market value never really widens up enough for the speculators to mount a sudden attack. Any differences in the supply and demand will be reflected automatically. As mentioned above, the floating rate is usually determined by the private market through supply and demand. This should reduce the negative impact of any external shocks. These reserves have an opportunity cost.
Thus, the possibility of international monetary crisis originating from exchange rate changes is automatically eliminated. The baht was at one time pegged to the U. Adverse Effect on Economic Structure: The system of flexible exchange rates has serious repercussion on the economic structure of the economy. However, a disadvantage of freely floating exchange rates is that firms are exposed to exchange rate risk and they have to manage it. So, keeping the exchange rate low ensures a domestic product's abroad and profitability at home.
Failure of Flexible Rate System: Experience of the flexible exchange rate system adopted between the two world wars has shown that it was a flop. Assume that this direct intervention is expected to be successful at influencing the exchange rate. This requires large amounts of reserves, as the country's government or is constantly buying or selling the domestic currency. Long-term foreign investments arc greatly reduced because of higher risks involved. If Japanese exporters do reduce their prices to fully offset the effect of the stronger yen, there would be less of a shift to Hong Kong goods.
Countries may become involved in rounds of competitive devaluations in order to capture a competitive advantage. More info Continuous currency volatility In consequence, floating exchange rates are in continuous fluctuation. First, they would lower the risk of speculative capital flows that could destabilize the economy. In theory, a fixed exchange rate should also reduce speculation in the foreign exchange markets. So even if a floating exchange rate has its set of flaws, it is more efficient in being able to determine the value of a currency as well as creating equilibrium in the international market. Another way of controlling exchange rate is to use foreign currencies.
This might also raise employment. As globalization has progressed, more countries have abandoned their currency pegs and have allowed their currencies to freely float. Shock Absorber: A fluctuating exchange rate system protects the domestic economy from the shocks produced by the disturbances generated in other countries. If the dollar weakened U. Exchange Rate Systems may be classified according to the degree by which exchange rates are controlled by the govt. International Trade not Promoted by Fixed Rates: The argument that fixed exchange rates promotes international trade is not supported by historical facts of inter-war or post-war period. It makes the exchange rate between the two countries constant and stable.
Still, many countries kept their currencies , because the dollar is the. Lack of investment — The uncertainty can lead to a lack of investment internally as well as from abroad. Would you purchase or sell call options on euros today? In other words, the fixed exchange rate system fails to gloss over the international competitive environment. These reserves can therefore be fruitfully used to import capital goods and other items in order to promote faster economic growth. Given that the euro is much stronger than the Vietnamese currency, a T-shirt can cost a company five times more to manufacture in a country, compared to Vietnam. Meade has pointed out that under the floating exchange rates system national governments enjoy considerable discretion.
Speculation not Prevented by Fixed Rates: The main weakness of the stable exchange rate system is that in spite of the strict exchange control, currency speculation is encouraged. The rate is set against another major world currency such as the U. However, these advantages also come at a price. Managed exchange rate systems permit the government to place some influence on an exchange rate that would otherwise be freely floating. Local producers must maintain low prices to remain competitive. A common element with all fixed or pegged foreign exchange regimes is the need to maintain the fixed exchange rate. It could be used for demand management policies.
Of course the rate changing will affect price and thus sales. An example for this would be controlling inflation. The dollar is used for most transactions in. In the short run, traders find it difficult to engage in foreign trade since they are not aware of the exact prices that their goods will fetch them. Governments that have sided with the idea of a fixed, or pegged, exchange rate are looking to protect their domestic economies. They peg it to either a single currency or to a basket of currencies.
A pegged exchange rate also supports a rising standard of living and economic growth. Uncertainty tends to be created. Manipulating supply and demand will only weaken the market. The value of currencies change on a real time basis. A fixed exchange rate has been proven to create global trade as well as provide monetary stability. Inflationary Effect: Flexible exchange rate system involves greater possibility of inflationary effect of exchange depreciation on domestic price level of a country. Promotes International Trade: The system of flexible exchange rates does not permit exchange control and promotes free trade.