Fixed Exchange Rate: Advantages and Disadvantages

Currency Management Systems

• A country has more control over its currency when it's undervalued, as it can gain large reserves of foreign currencies.

Undervalued Currencies

• China operates a managed float currency system, intervening when necessary to stimulate its markets.
• China previously operated a fixed exchange rate at around 8 RMB to the US dollar, but adjusted it when needed.

Free Floating Advantages and Disadvantages

• Advantages:
  • The floating exchange rate should adjust itself to keep the current account balanced.
  • No need to keep high levels of foreign currency and gold reserves.
• Disadvantages:
  • Creates uncertainty on international markets.
  • Affected by factors beyond demand and supply, such as government intervention and world events.
  • May worsen existing levels of inflation.

Fixed Exchange Rate Advantages vs Disadvantages

• Advantages:
  • Reduces uncertainty for economic agents in the country.
  • Ensures sensible government policies on inflation.
  • Reduces speculation in foreign exchange markets.
• Disadvantages:
  • Requires high levels of foreign reserves to defend the currency.
  • Setting the fixed exchange rate level can be challenging.
  • A fixed rate set too low may create international disagreement.

Effects of Exchange Rates on Economy

• High exchange rate:
  • Downward pressure on inflation.
  • More imports can be bought.
  • Forces domestic producers to improve efficiency.
• Disadvantages of high exchange rates:
  • Damage to export industries.
  • Damage to domestic industries.
• Low exchange rate:
  • Greater employment in export industries.
  • Greater employment in domestic industries.
• Disadvantages of low exchange rates:
  • Imports become more expensive.
  • Can lead to inflation.