Risks Associated With Fixed and Floating Exchange Rates

In an open economy with fixed exchange rates, the money supply is endogenous. This means that the money supply cannot be influenced by the government. Therefore, it implies that the money supply is solely used in the economy to ensure a stable exchange rate. Besides, the hands of the monetary authority are held tied. The central bank can control the high-powered money implying that it can control the money supply using tools such as foreign exchange market intervention and open market operations.

The central bank is obligated with the responsibility of maintaining stable exchange rates in an open economy through passive exchange intervention (Copeland 33). This is established by the purchase or sale of international reserves so that it can attain the stabilization of nominal exchange. This implies that International reserve cannot be controlled whereas Domestic Deposits can be controlled in an open economy with fixed exchange rates

A fixed or pegged exchange rate has several risks that are associated with it. A fixed exchange rate does not allow an automatic adjustment of the balance of payment, and as such, any disequilibrium in the economy can only be regulated by a decline in aggregate demand. The other risk is that the government needs to have large holdings of reserves in terms of foreign currencies. Holding such currency attracts an opportunity cost, and as such, a country may find it difficult to maintain such large foreign exchange reserves. Besides, it leads to a loss in internal policy freedom and this can adversely affect the economy.

The other point concerns the instability of fixed rates; this may limit the competitiveness of an economy and as such non-competitive countries may devalue their currency to remain competitive. This can result from the alteration of the rate by administrative fiat.

Floating exchange rates are determined by the market forces and as such, the economy faces the risks of uncertainty because prices fluctuate daily. Therefore, it brings confusion among importers and exporters since they are not sure of the exact price (Robert 25). Besides, it may act as an impediment to investment, and the economy is at risk of lacking investment both internal and foreign investment.

The other risk is that an economy is vulnerable to high inflation rates, and as a result, an economy will face adverse economic times. Furthermore, an economy will be exposed to the risks of speculation; this will destabilize and damage the economic performance of the country (William and Jackson 75). An economy that uses a floating rate will also face the risks of mounting deficits concerning the balance of payment deficits.

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