4.5 Conclusions

4.5 Conclusions

The clear result that emerges from this chapter is that neither the traditional advantages/ disadvantages approach nor modern literature provides a clear-cut reason to prefer fixed to floating exchange rates, or vice versa.Fixed rates have some advantages and disadvantages as compared to floating exchange rates.Indeed, many of the proposed advantages can, under some circumstances, be viewed as disadvantages.For example, floating exchange rates restore monetary autonomy, but whether this is a good or bad thing will depend upon whether the authorities use the autonomy wisely.While fixed exchange rates may promote international trade, a currency can at times become pegged at an overvalued exchange rate.This can result in trade frictions and the use of protectionism which curtails international trade.

The modern approach to evaluating the two regimes shows that only under very specific conditions can we say that one is better than the other.The analysis has focused on three crucial factors which determine the choice of exchange-rate regimes: the specification of the objective function, the type of shock impinging upon the economy, and the structure of the economy.In particular, the analysis highlighted the importance of the specification of the objective function and demonstrated how a slight modification to this can completely reverse the ranking of the regimes.Different countries, even if they have similar economic structures and face similar shocks, may well require different exchange-rate regimes simply because their objectives differ.

There are a host of other factors that will complicate the choice of exchange-rate regime, such as the implications of wages indexation, the possibility of permanent shocks, and relationships between various shocks.It should also be remembered that, in practice, it is extremely difficult to know if an economy is being afflicted by a supply or demand shock or a shock to money demand.Even if a shock is identified there is the question as to whether or not it is a permanent or transitory phenomenon.

The lack of decisive arguments in favor of either fixed or floating exchange rates has frequently been taken as a rationale for some degree of exchange-rate management between the two regimes.The argument is that such exchange-rate management has the potential to combine the advantages of both regimes while limiting the disadvantages.However, a demonstration that private speculation may produce the wrong rate, or that exchange rates are prone to “overshoot”, does not by itself justify intervention.It is necessary to demonstrate that the authorities can choose a more appropriate rate and that intervention can influence the exchange rate in the desired direction.In addition, it is necessary to demonstrate that intervention in the foreign exchange market is the best means of tackling the economic problem in hand.Instability of the exchange rate may merely be due to unstable macroeconomic policies by the country concerned, and the best means for reducing such fluctuations is to stabilize domestic economic policies, not to intervene in the foreign exchange market.

Since there is no unique case for exchange-rate management, there can be no unique set of rules expected to deal with the wide variety of circumstances that can arise.An appropriate intervention policy may involve reducing or exacerbating exchange-rate movements; intervention may need to be temporary or prolonged, and the amount of intervention required will vary with the circumstances.In other words, even if intervention can be justified, the precise direction, duration and volume of intervention required need to be determined.

Finally, it should not be forgotten that we have examined the choice between alternative regimes within the context of a specific model of a small open economy.One of the implications of the analysis is that different countries may need to opt for different exchange-rate regimes.It may be the case that the choice of exchange-rate policy by one country may well be a crucial factor in determining the choice of exchange-rate policy for other countries, and this is an issue that merits further attention.

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1.Exchange rates can be quoted in two ways: (1)the number of units of domestic currency for one unit of foreign currency, or (2)the number of units of foreign currency for one unit of domestic currency.Most financial centers use the first method and quote the number of units of domestic currency for one unit of foreign currency.

2.Advantages of the fixed exchange rates are: promoting international trade and investment; providing discipline for macroeconomic policies; promoting international cooperation and speculation under floating rates is likely to be destabilizing.

3.Advantages of the floating exchange rates are: ensuring balance-of-payments equilibrium; ensuring monetary autonomy; insulating economies; promoting economic stability and private speculation is stabilizing.

4.Since the advent of floating exchange rates in 1973 it has become evident that authorities have not always let their currency float freely, but rather they have frequently intervened to influence the exchange rate.A number of rationales have been put forward to justify such intervention and are worth consideration.

5.The arguments for some degree of discretionary intervention overlap to some extent, but fall into three main categories:

(1)The authorities can choose an exchange rate more in line with economic fundamentals than the market;

(2)Intervention is required to mitigate the costs of exchange-rate “over shooting”;

(3)Intervention is an appropriate instrument for smoothing necessary economic adjustments.