A central bank can choose to fix exchange rates to control the value of a local currency against other currencies irrespective of the trajectories of the forces of demand and supply (Kenen, 2000). The relative merits of a fixed exchange rate regime are as follows. First, it removes the uncertainty associated with currency fluctuation. Changes in the value of a currency can adversely affect import and export trade. Secondly, a fixed exchange rate regime protects the local economy from external economic shocks.
If the currency of a trading partner appreciates or depreciates significantly, a fixed exchange rate limits the exposure of the country. The third merit of a fixed exchange rate regime is that it can compensate for the weaknesses of a central bank (Kenen, 2000). Usually central banks have an important role to play because they have fiscal and policy instruments at their disposal. A weak central bank can compromise the economy if it misuses these tools.
Therefore, a fixed exchange rate regime limits the power of a central bank to affect market conditions. The fourth merit of using a fixed exchange rate is that it eliminates currency speculation (Kenen, 2000). Currency speculation can affect the economic development of a country negatively and can lead to inflation or deflation. Fixed exchange rate regimes eliminate this threat.
The relative merits of floating exchange rates are as follows. First, a floating exchange rate allows a country to develop its competitive advantages better than countries that have fixed exchange rates. Floating exchange rates force businesses to find efficient ways of handling international transactions to maximize their profits.
The cautious attitude leads to the development of competitive advantages. Secondly floating exchange rates gives central banks more options for handling economic pressure (Kenen, 2000). This means that the banks can control the economic shocks that may affect the country. The third relative merit of floating exchange rates is that they promote free market ideals, which is the proven model for rapid economic growth.
The important issues that every international business needs to consider when choosing an exchange rate regime are as follows. First, the business must consider its exposure to exchange rate shocks. If the business is at a very risky position due to potential changes in the exchange rate, then it should choose a fixed rate regime. However, this decision will eliminate some business opportunities. The second consideration is the number of countries where the business operates.
The main issue in this regard is the consideration of the overall exposure of the business to variations in exchange rate in its countries of operation. This will help it to make strategic decisions about the exchange rate regime to choose. Finally, the business must conduct a comprehensive cost-benefit analysis to determine how best to manage the risks and the opportunities of either model. Some businesses will have better rewards operating on a fixed rate regime, while other will prosper in a floating rate environment.
Ideally, fixed rate regimes are better for international businesses. The main argument supporting this assertion is the development of competitive advantages. Businesses that operate in floating rate environments develop their competitive advantages better than those that are in fixed rate environments.
Fixed rate environments tend to have protectionist policies. Such environments enforce limits to trade via regulatory measures. While such an environment is ideal for firms operating within the country, it is detrimental to the operations of businesses that have international interests.
Reference
Kenen, P. B. (2000). Fixed Versus Floating Exchange Rates. Cato Journal , 20 (1), 109-113.