Research Project on Foreign Exchange
Floating exchange rate is a price of one currency in terms of another currency or currencies which is influenced totally by the forces of demand and supply without government intervention.
The floating exchange rate is influenced by the balance between exports and imports. There is an example of pounds and dollars. When the UK exports their service or goods to the USA, the USA will demand pounds to get them. When the UK imports service or goods from the USA, the UK will supply pounds to the USA. There will be an equilibrium price to make those two forces equal (shown at figure 1). If the UK exports more goods and service to the USA than before, the demand of pounds of the USA will increase. Therefore, the price of pounds will rise (shown at figure 2). Conversely, the UK imports more and the price will decline (shown at figure 3).
The investment flows also impact the floating exchange rate. Assumed the exchange rate is £1=$2. If there is an increase in the level of investment in the UK from the USA, there will be a growth in the demand for pounds, the price will rise (see figure2).
Fix Exchange Rate
The fix exchange rate is a pegged price of one currency against another currency or currencies which is predetermined by the intervention of the government. Government is responsible to keep the fixed value and the central bank has to have supplies of foreign currencies to get ready for buying and selling the currencies at the fixed price. For example, it is assumed that the fixed exchange rate of £1=$2 has been agreed by both the UK and USA. At first, the demand and supply of pounds are in equilibrium at this rate (shown at figure 4). When the exports of the UK increase, the demand of pounds will increase. The curve of demand moves from DD to D’D’, the price will increase to £1=$2.5. In order to keep the fixed rate which is £1=$2, the central bank of the UK has to sell pounds to rise the supply from SS to S’S’ (shown at figure 5). In the other hand, if the imports of the UK go up, the cure of supply will move to S”S”, the central bank has to buy the pounds to rise the demand from DD to D”D” in order to keep the fixed exchange rate. (Shown at figure 6)
Thus, when the demand of one currency exceeds its supply at the fixed price, the central bank which is the tool to keep the fixed exchange rate of a country will sell this country’s currency on the foreign exchange market and add them to the reserves of foreign currencies, while when the supply exceeds, the central bank will the reserves of foreign currencies to buy the country’s own currency on the foreign exchange market
Before the First World War and for some time between the wars, there was fixed exchange rate in terms of gold, which called gold standard. From the Second World War, there was another fixed exchange rate system called Breton Woods System.
The Advantage of Floating Exchange Rate
Disadvantage of the Floating Exchange Rate
Advantages of the Fixed Exchange Rate
Disadvantage of the Fixed Exchange Rate
The floating exchange rate is influenced by the balance between exports and imports. There is an example of pounds and dollars. When the UK exports their service or goods to the USA, the USA will demand pounds to get them. When the UK imports service or goods from the USA, the UK will supply pounds to the USA. There will be an equilibrium price to make those two forces equal (shown at figure 1). If the UK exports more goods and service to the USA than before, the demand of pounds of the USA will increase. Therefore, the price of pounds will rise (shown at figure 2). Conversely, the UK imports more and the price will decline (shown at figure 3).
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It is also affected by the capital transactions between one country and other countries. Some speculators buy foreign currencies when they are expected to rise and sell them when they are expected to fall to make some profits. If these transactions are in large scale, it can influence the exchange rate a lot.
The investment flows also impact the floating exchange rate. Assumed the exchange rate is £1=$2. If there is an increase in the level of investment in the UK from the USA, there will be a growth in the demand for pounds, the price will rise (see figure2).
Fix Exchange Rate
The fix exchange rate is a pegged price of one currency against another currency or currencies which is predetermined by the intervention of the government. Government is responsible to keep the fixed value and the central bank has to have supplies of foreign currencies to get ready for buying and selling the currencies at the fixed price. For example, it is assumed that the fixed exchange rate of £1=$2 has been agreed by both the UK and USA. At first, the demand and supply of pounds are in equilibrium at this rate (shown at figure 4). When the exports of the UK increase, the demand of pounds will increase. The curve of demand moves from DD to D’D’, the price will increase to £1=$2.5. In order to keep the fixed rate which is £1=$2, the central bank of the UK has to sell pounds to rise the supply from SS to S’S’ (shown at figure 5). In the other hand, if the imports of the UK go up, the cure of supply will move to S”S”, the central bank has to buy the pounds to rise the demand from DD to D”D” in order to keep the fixed exchange rate. (Shown at figure 6)
Thus, when the demand of one currency exceeds its supply at the fixed price, the central bank which is the tool to keep the fixed exchange rate of a country will sell this country’s currency on the foreign exchange market and add them to the reserves of foreign currencies, while when the supply exceeds, the central bank will the reserves of foreign currencies to buy the country’s own currency on the foreign exchange market
Before the First World War and for some time between the wars, there was fixed exchange rate in terms of gold, which called gold standard. From the Second World War, there was another fixed exchange rate system called Breton Woods System.
The Advantage of Floating Exchange Rate
- A floating exchange rate is an automatic mechanism for keeping the balance of payments in equilibrium. Because the exchange rate is determined by the forces of supply and demand of the currency, it is very easy to find the problems with the balance of payments in equilibrium by the change of exchange rate. When this country imports more than exports, the supply of its currency will exceed the demand. Consequently, the exchange rate of this currency will fall. The exports will be cheaper and imports become more expensive. The change of the exchange rate alter the terms of trade but whether the adjustment will bring beneficial impact on the balance of payments depends on the elasticity’s of the demand and supply of exports and imports(demand of exports are shown in figure7). If they are elastic, the government should add exports and reduce imports.
- The government can be confident in a floating exchange rate system. Government need not to buy or sell own currency to maintain the exchange rate. Every country can decide its own monetary policy according to the different situations.
- The government need not to hold too much reserves of foreign currency to fix the exchange rate. Therefore, this country can import more foreign goods and service and invest more on home economy; as a result this country can make a lot of progress on economy.
- The inflation from abroad only can influence the exchange rate of one country but can not affect the reserves of foreign currencies of this country,
- It prevents a country to making the exchange rate be a target. The government will not have to introduce measures to keep the value of the currency at a pegged price which might threaten its objective.
Disadvantage of the Floating Exchange Rate
- The mainly disadvantage is that the floating exchange rate is an element of uncertainty to international trading. The uncertain prices of world-wide goods lead to high risk for international trade, so there are very few long-term contracts, credits and investment. The buyers have to pay attentions on tow sides: the foreign price for the goods and service and the exchange rate of the currency. If the exchange rate of the country’s currency declines proportionately more than the foreign price of the goods or service, the price for importers is rise , whereas if the exchange rate of the country’s currency rise proportionately more than the foreign price of the goods or service, the price for importers is drop. For example, it would be possible the prices of televisions made in Japan declines but the dollars declines proportionately more than that price. As a result, the price for American importers is an increase.
- The floating exchange rate removes the pressure of dealing with the problems which caused by inflation, because the changes of currency will not prejudice exports. In fact, the lower price of this currency in the foreign exchange market will affect the imports be more expensive and leads to cost-push inflation. Therefore, the domestic economy still cannot avoid the influence by external force in the floating exchange rate system.
- Floating exchange rate leads to the uncertainty of countries international debt paying ability. For example, if countries pay debt in dollars, the ability of paying debt will change along with dollars. Dollars increase, the ability increase, dollars decrease, the ability decrease.
- Speculators who are not welcome appear in the floating exchange rate system. They can be destabilising and unsettling to markets
Advantages of the Fixed Exchange Rate
- The fixed rate of currency courage international trade. There are more long-term contracts, long –term credits and long-term investment because of the less risks in the fixed exchange rate system. More convenient for buyer to get the price levels because they only need to watch the change of the foreign price of the commodity. When the foreign price increases, it is an increase for importers. Conversely, the price is a decrease for them.
- A fixed exchange rate helps a country deal with inflation. The government is responsible to keep the fixed price of its currency, so it is not be able to rely on a fall in the exchange rate, thereby there will be more pressure to force the government to solve those problems.
- The debt paying ability is mote stable than it is when it is under floating exchange rate system.
- There are fewer speculators in this system. It is not so easy to make big profits when the currencies at certain prices.
Disadvantage of the Fixed Exchange Rate
- There is no longer an automatic mechanism to keep the balance of payments. Government not only has to support the exchange rate but also to deal with the problems with the balance of payment.
- A fixed exchange rate cannot support the countries in the situations of persistent deficits or surpluses. In the event of surplus, if the surplus persists then it has to revalue to keep the fixed price of the currency. For deficits, the country holds the reserve of foreign currency to keep the value of its currency. Therefore, the government have to devalue the currency.
- The country also will use tariffs and quotas to keep the fixed price of the currency. This may cause raise price on the home economy and deflationary measures which will harm domestic employment and growth.
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