The debate on the impact of currency regimes on economic activities is on the current agenda due to the emerging financial and debt crises. The international economy has bright examples of how exchange rate fluctuations and currency systems have been adopted to regulate both domestic and international markets.
This paper focuses on the analysis of the various forms of currency regimes and their influence on both developed and developing economies. Specific attention is given to the literature that reviews historic evidence about currency unions, as well as small open economies in which financial activities are tied to a specific monetary policy.
The focus is also on advantages and disadvantages of fixed and floating currency regimes in various economies. Development of various forms of currency regimes and exchange rates shape the peculiarities of activities in various economies. In fact, fluctuations in currency rates have a potent impact on economic variables, including market liquidity, monetary policy, and financial system.
The most common currency regimes involve floating exchange rates and fixed exchange rates that can bring in both beneficial and adverse effects on economic activities. In particular, floating exchange rate can enable monetary policy makers to pursue various goals, such as stabilizing the employment rate and prices.
Floating exchange rate is advantageous in case of currency depreciation or appreciation because the central bank can always manage the fluctuation. At the same time, flexible currency systems have adverse effect on emerging economies in terms of its negative impact on financial activities. At this point, fixed exchange rate is more beneficial for economies in which monetary policy is focused on maintaining the fixed currency rate.
With regard to the above-presented functions and purpose of the currency regimes, economic activities are closely associated with changes to the currency systems in terms of financial processes, price stabilization, market demand and supply, and foreign exchange rates (Mark 2009).
Looking from a microeconomic perspective, the choice of monetary policy regime relies on financial differences and business cycle systems. To explore this issue, Faia (2007) focuses on the connection between currency regimes and business cycle networks across countries.
The researcher also proposes an integrated framework in which business cycle co-movements relate to the differences between various financial systems, as well as monetary systems adopted by various economies. The European Union serves as an evident example of how a singly currency regime can be adopted despite the presence of various financial structures predetermined by legal frameworks, history, and politics.
Within this perspective, Faia (2007, p. 152) emphasizes the central role of financial and banking structures, by stating that “a lesser financial diversity increases the cyclical correlation for any given monetary regime, whereas moving from independent monetary policies to a currency peg or even more to a common currency tends to increase it”.
Such a perspective explains the reasons for adopting fixed currency regime in developing and emerging economies. The case of the European Union as a singly currency system proves that exchange rate contributes to the creation of economic unions with a single currency.
While examining the Scandinavian Currency Union, Bergman (1999) has pursued the historical perspective on currency regimes formation, particularly the challenges that Scandinavian economies had to face. Despite the skepticism surrounding the currency economic networks, the Scandinavian Currency Union was considered as one of the most successful because “…countries facing similar types of shocks and having similar economic structures are ideal candidates for a monetary union” (Bergman1999, p. 364).
At the same time, the economies involved in long-term trade relations with countries outside the union can experience problems because of a single exchange rate policy, being the negative side of debate. Development of a single currency regime does not contribute to flexibility of the exchange rates that can cause financial instability.
Moreover, the 2002 debt crisis in Argentina signifies that extreme liquidity and dollar-dominated debt can become the major reason for economic recession (Besancenot and Vranceanu 2007). Moreover, excess focus on the foreign exchange market can become a serious threat to developing economies because it can be vulnerable to exchange rate fluctuations (Charlebois and Sapp 2007; Mark 2009).
Therefore, developing new exchange market options should be introduced for sustaining successful economic activities and predicting the risk of default. Analysis of large economic unions has revealed the advantages and disadvantages of the floating currency regimes. However, open-economy context implies the comparison of both floating currency and fixed currency regimes.
At this point, Hernandez-Verme (2004, p. 840) explains, “floating exchange rates, raising domestic inflation can increase long-run output is credit is rationed”, whereas “with fixed exchange rates, the domestic country inherits the inflationary experience”. Similarly, Kandil and Mirzaie (2005) focus on the impact of exchange rate fluctuations on pricing policies and real output.
Based on the empirical evidence receive from 33 developing economies, the scholars have discovered that unpredicted currency fluctuations affect the increase in demand for domestic currency, as well as in export and import activities. Moreover, the currency depreciation has reduced influence on price inflation and output growth through supply channels.
In addition, Antinolfi and Hybens (2004) focus on the financial activities in small open economies to define the common strategies for managing currency fluctuations. In particular, the researchers refer to the 1990’s crisis to explain the negative consequences of flexible exchange rates for the development of emerging economies.
Due to the threats posed by both fixed and floating exchange rates, most scholars debate on the choice of the optimal currency system. At this point, Cukieman et al. (2004) suggest their model under which the exchange rate uncertainty should be measured with regard to the value of unpredicted nominal appreciation/depreciation.
In support to the studies by Cukieman, et al. (2004), Bleaney (2000) agrees that the currency regime can affect the reaction of monetary policymakers toward the inflation shocks. However, flexible monetary system can be much more persistent in terms of inflation because they are regulated by the central bank.
Overall, the literature review shows certain patterns and conformities in the influence of various currency regimes on economic activities. To begin with, flexible currency regimes are more relevant for developed economies that are engaged in mutual commercial relations because they are regulated by the central bank whereas the developing economies should rely on fixed currency rates to sustain financial stability and successful business management.
Second, the flexible exchange rates have a direct impact on pricing and employment rates that benefit from this particular regime. In contrast, fixed currency systems influence on the countries capability to establish international trade relations. In fact, they may encounter serious challenges while engaging into import and export activities. Finally, exchange rate fluctuation can cause dollar-dominated debt crisis for countries with a fixed currency system.
Reference List
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Bergman, UM 1999, ‘Do Monetary Unions Make Economic Sense? Evidence from the Scandinavian Currency Union, 1873-1913’, The Scandinavian Journal of Economics, vol. 101, no. 3, pp. 363-377.
Besancenot, D, and Vranceanu, R 2007, ‘Financial Instability under a Flexible Exchange Rate’, The Scandinavian Journal of Economics, vol. 109, no. 2., 291-302.
Bleaney, M 2000, ‘Echange Rate Regimes and Inflation Persistence’, IMF Staff Papers, vol. 47, no. 3, pp. 387-402.
Charlebois, M and Sapp, S 2007, ‘Temporal Pattern in Foreign Exchange Returns and Option’, Journal of Money, Credit and Banking, vol. 39, no. 2/3. pp. 443-470.
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Hernandez-Verme, PL 2004, ‘Inflation, Growth and Exchange Rate Regimes in Small Open Economies’, Economic Theory, vol. 24, no. 4, pp. 839-356.
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