at the end of the lesson u should be able to: assess the advantages and disadvantages of floating ER system vis-à-vis the fixed ER system

Advantages of Floating ER system (disadvantages of fixed)

Automatic correction of CA position Fluctuations in the exchange rate can provide an automatic adjustment for countries with a large CA deficit. If an economy has a large deficit, there is a net outflow of currency from the country. This puts downward pressure on the exchange rate and if a depreciation occurs, the relative price of exports in overseas markets falls (making exports more competitive) whilst the relative price of imports in the home markets goes up (making imports appear more expensive). This should help reduce the overall deficit in the balance of trade provided that the price elasticity of demand for exports and the price elasticity of demand for imports is sufficiently high.

Greater freedom to pursue domestic policies The flexible ERs make the CA self-correcting, govt faced with a CA problem do not have to set aside other objectives in order to deal with this problem. e.g. it gives the government / monetary authorities flexibility in determining interest rates. This is because interest rates do not have to be set to keep the value of the exchange rate within pre-determined bands.

Reduces need for official reserves Unlike the fixed ER system where the govt. has to intervene to buy its currency using its reserves when its ER falls, there is no need for govt in the floating ER system to intervene. Therefore there is no need to hold large reserves.

Protection from inflation abroad With fixed ER system, inflation abroad can be transmitted directly into the country in the form of higher import prices. e.g. If the ER between £ and $ is fixed at £1 = $2, an American product, priced at $200 will be sold in UK for £100. If the price of M increases to $300, UK must now pay £150. However, a flexible ER helps to insulate a country from inflation abroad. e.g. If USA has inflation compared to UK, this will cause USs goods to be dearer M ER of £ and UK will now pay less for the M and not more.

Disadvantages of Floating ER system (advantages of fixed)

Fluctuating ER causes uncertainty A seller may be unsure of how much money he will receive when he sells his goods abroad. He may have work out a satisfactory profit level on the sale of a particular product, based on the current ER. But, if the ER changes greatly in the meantime, by the time the sale is completed, he may find his profit level has reduced, disappeared or increased.

1a) Uncertainty discourages International trade E.g. an importer buys a good at US $100 = RM 340 today. (assume ER is US$1 = RM3.40) If ER of ringgit falls to US$1 = RM4), he has to pay RM____ (on which he suffer a loss) E.g. an exporter sells a good RM 340 = US $100 today. (assume ER is US$1 = RM3.40) If ER of ringgit rise to US$1 = RM3, he will receive US$100 = RM ____ (on which he may suffer a loss)

1 b) Uncertainty discourages Investments Instability of ER causes uncertainty. Businessmen hates uncertainty. Especially when the ER is highly unstable, they may be discouraged to invest. A fall investment means cutting back production national output unemployment

Encourages destabilizing speculation The day-to-day changes in ER may encourage speculative movements of 'hot money' from country to country, thus making changes in ER greater. For e.g. if ER of £ is falling and the speculators believe that the £ against the $ is going to fall furthur, they will use their holdings of £ to buy dollars, wait for the ER to fall and then use $ to buy a greater quantity of £. Downward speculations will cause the currency to fall. Such speculations can have a destabilizing influence such as the Asian financial crisis at end 1997 Fall in ER causes investors to lose confidence in the economy. This will cause Investment to AD NY. > $1 trillion worth of currencies are traded in the forex market. The reserves of most countries are trivial in comparison. It will be difficult for many countries to defend their currencies against excessive speculations.

Fixed versus Floating Exchange Rates Advantages of free-floating rates –automatic correction –insulation from external events/inflation –less constraint on domestic macro policy Disadvantages of free-floating rates –possibly unstable exchange rates –speculation –uncertainty for business but use of forward markets

Fixed versus Floating Exchange Rates Advantages of fixed exchange rates –certainty –no speculation (if rate is absolutely fixed) Disadvantages of fixed exchange rates –conflicts with other macro objectives –need to hold sufficient reserves to intervene –no protection against inflation abroad

Purchasing Power Parity theory explains the relationship between the exchange rate and the price level in different countries. The PPP theory states that, over the long run, ER changes in line with different inflation rates between countries. meaning the exchange rate of a currency changes to reflect the relative rise or fall in its purchasing power

PPP theory PPP exists only when the same bundle of goods cost the same in both countries after adjusting for ER diffences theory has as its foundation the law of one price. E.g if ER is £1 = US$2 If P latte in UK = £2 & P latte in US = US$4, PPP exists If P latte in UK = £2 & P latte in US = US$3 or $5, PPP does not exist

Purchasing Power Parity theory the Big Mac serves as a convenient basket of goods through which the purchasing power of different currencies can be compared.

Purchasing Power Parity theory E.g. If the price of a price of a Big Mac in the UK was £2.00 and in Europe 3.00, the exchange rate between the two countries should be £1 = 1.50 If any lower than this value, the £ would be undervalued and if any higher, the £ would be overvalued

Purchasing Power Parity theory The price of £ in the foreign currency = Foreign Country price level/UK price level