The Advantage of a Fixed Exchange Rate
The advantage of a fixed exchange rate is that it ensures price stability in the international market, preventing undesired price changes. Because of the lessened volatility in the financial markets, this ensures economic stability and prosperity. Pricing fluctuations create variations in output and, as a result, economic downturns owing to volatility. Price stability ensures that major, unexpected price swings in the market are avoided. A fixed exchange rate also promotes economic stability in the short and long run, as well as a reduction in uncertainty in international trade.
The Forex Market and Floating Exchange Rate
The forex market determines the floating exchange rate based on supply and demand dynamics. Due to this dependence on forces of demand and supply, it is a regime that causes significant insulation for a nation's economic problems. Floating exchange rate is characterized by high levels of volatility. In the case of undesirable macroeconomic conditions such as inflation in one country, it has an impact on other nations which import from the country. The high volatility evident in floating regime leads to an increase in the exchange rate risk and primarily in the financial market. Floating exchange rate does aggravate the existing macroeconomic. The uncertainty related to flexible exchange rate leads to a reduction in trade and level of investment in a nation. Uncertainty causes fluctuations in the product prices and inflation level. The increased product process makes the products become expensive and thus driving away potential investors. Besides, uncertainty in price stability causes unpredictable in the interest rates and thus leading to a reduced level of local and foreign investment. High levels of interest rates make it expensive for potential investors to borrow money.
Monetary Autonomy and Floating Exchange Rate
Floating exchange rate makes the central bank through monetary autonomy to have an effect on its money supply in attempts to stabilize domestic economic instabilities. The central bank can control the money supply through raising and lowering of the domestic interest rates in an attempt to impact on the economic growth and thus spur investment. The monetary policy is thus able to cause reductions in the level of unemployment and rising level of inflation. Through monetary autonomy depicted in the floating exchange rate, the monetary policy becomes a viable tool in controlling the adverse macroeconomic variables and foster a balance of the performance of the domestic economy (Appleyard and Alfred 45). In a fixed exchange rate regime, monetary autonomy is an ineffective tool as the fixed exchange rate become a major inhibiting constraint in implementing monetary policy tools. If the money supply is raised in a floating exchange rate, it will lead to a reduction in the domestic interest rates and thus make the foreign asset to be considerably attractive.
Equilibrium Interest Rate, Money Supply, and Money Demand
The graph indicates the equilibrium interest rate, money supply, and money demand. Expansionary fiscal policy causes the IS curve to shift right making the local currency to appreciate. As a result, domestic investors will increase their demand for foreign currencies and thus make the local currency depreciate against the foreign currency. The adjustment mechanism of the floating exchange rate through the monetary policy assists in maintaining both external and internal balance of trade and the current country account. Floating exchange rate enables a nation's monetary policy committee to be able to intervene in the financial market in times of economic turbulence and thus lowering pressures that arise from the skyrocketing interest rates in a nation.
Automatic Stabilization and Floating Exchange Rate
Floating exchange rate causes automatic stabilization of the equilibrium prices. This is because prices in the market are allowed to follow the forces of demand and supply and thus lead to new equilibrium levels. The automatic stabilizer has an impact on offsetting the fluctuations experienced in the economic market without interventions from the policymakers. When there is high demand for either the local or the foreign currency, the forces of demand and supply will lead to an equilibrium level in a floating regime.
Switzerland and Floating Exchange Rate
Switzerland is an example of a country that initially operated under the fixed exchange rate. However, in 2014, Switzerland unpegged its Swiss franc currency and adopted the floating exchange rate regime. In the 2008-2009 financial crisis, many markets were driven into turmoil due to the floating exchange rate. As a result, many investors consider the Swiss franc currency a safe place for asset investment like bonds. The pegged exchange rate made many investors reason that their asset investment faced huge financial risks in a floating exchange rate and consequently, numerous investors flocked to Switzerland (The Economist). Hence, the value of the Swiss franc dramatically went up and significantly had an impact on the level of exports. Exports became expensive in the international market and thus caused a huge reduction. Exports make 70% of Switzerland's GDP, and thus the nation suffered low levels of GDP.
The adverse effects brought by having the fixed exchange rate during the financial crisis caused Switzerland to adopt the floating exchange rate regime. The aftermath of this move resulted in devastating impacts on various economic variables. The introduction brought panic due to the soaring of the Swiss franc currency and the number of funds that were hedged resulted in significant losses along with the collapse of the Swiss franc stock market. The country's foreign exchange reserve was threatened, and fears arising from the mounting levels of inflation proved to be depression. The Swiss franc depreciated against foreign currencies and also led to a reduction in market capitalization.
Works Cited
Appleyard, Dennis R, and Alfred J Field. International Economics. 1st ed., New York, Mcgraw-Hill Companies, 2014,
The Economist. Why the Swiss unpegged the franc. (2015). Accessed on June 10, 2017 from http://www.economist.com/blogs/economist-explains/2015/01/economist-explains-13
