Description
2 classmates responses, with references
One: Amadeo (2020) of The Balance, defines a fixed exchange rate as follows: “A fixed exchange rate is when a country ties the value of its currency to some other widely-used commodity or currency. The dollar is used for most transactions in international trade although some countries also fix their currencies to that of their most frequent trading partners.” In comparison, “a floating exchange rate refers to a currency where the price is determined by supply and demand factors relative to other currencies. A floating exchange rate is different from a fixed – or pegged – exchange rate, which is entirely determined by the government of the currency in question.” (IG, n.d.) I would define a fixed exchange rate as one that has more alignment with the global standard (U.S. Dollar or Other Currency) and a floating exchange rate as one that is determined by the local governments’ policies and supply and demand.
As it relates to multinational businesses, I would heir on the side of a fixed exchange rate due to the advantages it offers as far as stability. This is mainly due to the advantages offered by the fixed exchange rate, namely, in that it provides certainty and encourages trade and investment due to the interdependency that the fixed exchange rate has to it’s perceived value (U.S. Dollar). A fixed exchange rate also benefits businesses due to fewer currency fluctuations and that created stability encourages investment. (Pettinger, n.d.) Understanding the perceived value leads to avoidance of devaluation of currencies.
Some of the disadvantages I can foresee for a fixed exchange are that it is less flexible because of the inability to devalue and reduce the current account deficit. (Pettinger, n.d.) Entering into a fixed exchange rate can also be disadvantageous from the perspective of higher interest rates. If a currency falls below the threshold or floor, a country can be forced to raise interest rates to maintain currency value. “However higher interest rates will cause lower aggregate demand (AD) and lower economic growth, if the economy is growing slowly this may cause a recession and rising unemployment.” (Pettinger n.d.) Which can be seen as a catch twenty-two for any country whose strategy is to raise its respective currency value.
References:
Amadeo, K. (2020, January 15). Fixed Exchange Rates: Pros, Cons, and Examples. Retrieved April
2, 2020, from https://www.thebalance.com/fixed-exchange-rate-def…
Hill, C.W.L & Hult, G.T.M. (2019). International Business: Competing in the Global
Marketplace. (12thedition). New York: McGraw-Hill Education.
IG (n.d.). What is a Floating Exchange Rate? Retrieved April 2, 2020, from
https://www.ig.com/en/glossary-trading-terms/floating-exchange-rate-
definition
Pettinger, T. (n.d.). Advantages of fixed exchange rates. Retrieved April 2, 2020, from
https://www.economicshelp.org/macroeconomics/excha…
Two: Formerly, the gold standard was applied as the foreign market currency exchange. Currencies were pegged to gold, much like the use of fixed exchange rates, and this determined the value of each foreign territory’s currency relative to another (Hill & Hult, 2019). In 1944, a new international monetary system was developed in Bretton Woods, New Hampshire, and two multinational institutions were established – the International Monetary Fund (IMF) and the World Bank (Hill & Hult, 2019). The IMF decided to apply a fixed exchange rate system and pegged the United States dollar to the value of gold. Other countries would then express the value of its currency relative to the value of gold in US dollars. Thus, we can observe that the fixed exchange rate system was applied before the floating exchange rate system.
The fixed exchange rate system carries many advantages. For instance, it can reduce uncertainty. Floating exchange rate systems highly fluctuate and can change each second of the day during trading hours. Thus, some businesses can be subjected to more risk in the international trade market because total costs consistently vary. This limits speculation and creates more stability for trading. On the other hand, a fixed exchange rate system uses monetary policy to put pressure on an economy to expand or contract its money supply to maintain its exchange rate parity (Shambaugh, 2004). Additionally, fixed exchange rates may provide a disadvantage when the currency is pegged to experiences an economic crisis. For instance, if a country is pegged to the Euro and the Euro experiences a heavy decrease in value due to an economic crisis, that country will have to adjust its currency value to the depreciation of the Euro. This event can prevent a smaller country from bouncing back unless it has a large supply of monetary reserves.
Floating exchange rate regimes rely on the market-based supply and demand of its currency relative to another (Mitchell, 2019). In contrast to fixed exchange rates, the government does not determine the value of its currency. Floating exchange rate systems can carry many advantages. For example, the exchange rate is self-adjusting and will change based on the supply and demand of its currency and trade. In other words, if the country is experiencing a current account deficit and the demand for exports is low, the price of the currency will depreciate. Once the value of the currency has depreciated to a certain degree, the demand for exports will begin to increase again. Thus, floating exchange rates can affect the balance of trade. This decreases the need for government intervention of monetary contraction and expansion (Hill & Hult, 2019). However, there are several disadvantages to the use of a floating exchange rate. As previously stated, floating exchange rate regimes experience high volatility from speculation. Investors and traders prefer to have some level of certainty to reduce risk. Other countries may not want to engage in business with a country that experiences such high volatility in exchange rates. Also, from heavy fluctuation, it can be difficult for countries to develop a long-term strategy from the level of uncertainty (Mitchell, 2019). This can create difficulty when a country wants to allocate its resources. What may seem like a good strategy today, may not be in the near future.
For multinational enterprises and Foreign Direct Investment (FDI), there are several criteria that should be considered when choosing between these exchange rate systems. One criterion is the uncertainty caused by speculation. Large businesses may be able to withstand heavy fluctuations in the exchange rate markets, while smaller businesses may want more stability. With uncertainty there is a risk. The higher the risk, the higher the reward. However, smaller businesses may experience failure due to unpredictability from cost increases. Another criterion is the interconnectivity between exchange rates and trade balance adjustments. In fixed exchange rate regimes, the government would need to implement a monetary policy to maintain exchange rate parity. This leads to slow adjustments in the market and countries can experience trade deficits or surplus for longer periods of time. In floating exchange rate regimes, the exchange rate markets adjust itself from the supply and demand of its currency.
References
Hill, C. W. L. & Hult, G.T.M. (2019). International Business: Competing in the Global Market Place (12th Edition). New York, NY: McGraw Hill Education.
Mitchell, C. (2019). Floating Exchange Rate. Retrieved on March 31, 2020, from https://www.investopedia.com/terms/f/floatingexchangerate.asp.
Shambaugh, J. C. (2004). The Effect of Fixed Exchange Rates on Monetary Policy. The Quarterly Journal of Economics, 119(1), 301-352
