Importance of Exchange Rates in world economies

Essay by pk_illusionHigh School, 12th gradeA-, December 2004

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The Case for Float Exchange Rates:

- autonomy of Central Bank

- symmetry among countries

- spot rate provides a clear market signal; automatically

adjusts to "clear markets"

- market is the best mechanism for restoring equilibrium

- speculators provide stability

- free flow of capital between markets

The Case against Float Exchange Rates/

The Case for Fixed Exchange Rates

* fixed rates impose discipline on monetary policy

* reduce volatility in prices; uncertainty

* avoid costly hedging of exchange rate risk

* destabilizing speculation held in check.

* avoid exchange rate "overshooting"

* inflation stabilization

Floating exchange rates play an important role in facilitating adjustment to asymmetric disturbances and thereby promoting stability. Thus, a falling-off in demand for the export products of any one country may lead to growing unemployment if it is unable to lower the external value of its currency by easing its monetary policy. This advantage is compounded by disturbances calling for reductions in the real wage level.

Since nominal wages are slow to change, such disturbances may cause significant oscillation in the unemployment rate.

Floating exchange rates are not, however, the only means by which an economy can adjust to shocks from outside. Other instruments for stabilizing the economy after a shock include capital movements, fiscal policy, flexible wages and other costs, and the mobility of production factors.

It is important to stress that floating exchange rates are a means for the national economy to adjust to major shocks from outside. In the case of disturbances affecting one sector only, changing the exchange rate may not be justified. Nor does a floating rate provide adequate protection against disturbances of domestic or monetary origin, such as inflationary wage hikes. At worst, the floating rate may contribute to the perpetuation of economic instability; cautionary examples can be...