The dollar is the main currency used in the transactions of most international businesses. However, this does not mean that it is the best performing currency in the world. Most currencies are exchanged for the dollar and that has made it universally accepted as a measure of value and a medium of exchange.
The terms and the conditions of the exchange rates can either have a positive or a negative impact on the economic growth of a given country. Exchange rate is defined as the price of a country’s currency in comparison with that of another country’s currency (Jongwanich 2006).
Every country desires to move forward in economic growth and that necessitates the application of the best strategies to ensure that the desired results are achieved. However, analysts have not been able to come up with the best exchange rate regime that can result to economic prosperity. Different studies on this matter have been carried out but the conclusion is yet to be made.
Economic development requires the application of the appropriate exchange rates. This is because the kind of exchange regime adopted by a country determines its macroeconomic performance. Therefore, the choice of the exchange regime to be adopted by any given country is of great importance to international finance and in other aspects of economics.
The way these rates affect the economic growth of a given country is highly based on the status of that particular state in terms of development. There are four main types of exchange rate regimes: fixed exchange rates, the flexible exchange rates regimes, managed floating exchange rates and the exchange control rates (Yarbrough & Yarbrough 2006, p. 37).
The fixed exchange rates are also known as the pegged exchange rates while the flexible exchange rates are referred to as the floating exchange rates. The managed floating rates are a combination of the good aspects of the fixed and the floating exchange rates.
In exchange control rate, the government is the controller of the allocation and the pricing of foreign currency (Yarbrough & Yarbrough 2006, p. 37).
The choice of an exchange rate regime should be done with a lot of consideration because it affects the domestic economy (Jongwanich 2006). It should be well understood that adopting a certain exchange regime does not a guarantee the desired macroeconomic results.
Therefore countries should not put all their hopes in the exchange rate regimes that they decide to make use of. Never the less, countries that adopt a fixed exchange rate regime are said to reduce their rate of inflation. Today, Inflation is the greatest problem that is affecting many economies in the world. Perhaps this is because most economies have turned away from fixed exchange rate regimes since 1970’s.
However, there is no a clear prove that the fixed exchange regime is the best in economic growth performance. A positive growth in the economy of a given country brings about tangible developments. Citizens enjoy the sweet fruits that come with an improved economy. They do not experience a lot of economic difficulties and that results into more developments.
Developed and developing countries have got different choices of exchange regimes. The problem with developing countries is that they are disadvantaged by the fact that they do not have proper access to international markets. They do not have deep financial markets and dependable financial institutions.
They also lack credibility and are faced with high liability dollarization among other problems. Since the early 1980’s these counties have been using flexible exchange rates. The fall of fixed exchange rates came around four decades ago when the Bretton Woods system of fixed rates collapsed (Yarbrough & Yarbrough 2006, p. 322).
Experts advise that this kind of regimes should not go on for a long time. According to them different exchange rate arrangements can lead to macroeconomic stabilization if the favorable conditions are created. This brings about an increase in gross and net capital flows in all kinds of markets.
The international monetary and financial environment can have an effect on the changing of exchange rate regimes and this is what has been happening (Gandalf 2002). The world has witnessed a significant improvement in technology especially with the coming of computers and the innovation of the internet.
This is the greatest kind of innovation that has been of great advantage to mankind. It has greatly improved the process of communication as people are able to pass and receive messages from any corner of the world within seconds.
This has resulted to a reduction in transaction costs and encouraged the creation of financial innovations. It has also lead to liberalization and made both domestic and international business transactions easier. People are now engaging in online business whereby goods and services can be sold and purchased through the internet.
The parties involved in the business do not have to meet physically. For sure, advancements in technology have had a great positive impact on the economies of different countries. They have created employments for many people who would otherwise be unemployed.
Apart from the positive impact of advanced technology, emerging market economies are enjoying the benefits of globalization as they continue to integrate in the world economy (Klein & Shambaugh 2010). The world has witnessed an increase in international trade. Many countries continue to come on board and trade with a number of others.
This follows the reduction and the ban on tariffs by different states which have worked to the advantage of the less fortunate and more so, the developing countries.
This coupled with favorable conditions governing international business transactions has enabled states that initially did not take part in the business indulge in it. As a result, there has been an increase international economic activity which has improved the economy of many states.
Even after the September 11th terrorist’s attacks in the United States of America, the dollar continues to outdo other currencies as it continues to depreciate (Klein & Shambaugh, 2010). Many would have expected the country to suffer great economic setbacks but there has been very little of that. For quite a long time, the dollar has been the main currency used in international markets.
This has had a negative impact on the exchange rate between major currencies which have been marked by large fluctuations. However, the launch of the Euro in international trade could reverse the situation as it would create a multi polar currency system.
Therefore people will stop depending on the dollar as the only means of exchange. This could possibly stabilize the exchange rates between different currencies which would be to the advantage of those taking part in international trade.
Economic experts advise that flexible exchange rates are in a position to correct the balance of payment disequilibria. They argue that this kind of rates can create internal balance in the economy of a country. On the other hand, those who advocate for fixed exchange rates argue that flexible exchange rates can lead to the reduction of international trade and investments (Gandalf 2002).
According to these people, this kind of exchange rates can destabilize the economy and cause inflation. Due to increased capital mobility, developing countries that make use of flexible exchange rates are likely to gradually loose the real value of their domestic assets. This would cause more problems and have a negative impact on the economy of such countries.
Advocates of fixed rates argue that the pegged rates are important in the correction of an unstable monetary and financial polices as they assist in streamlining erratic policy makers. Unlike flexible exchange rates, fixed exchange rates increase credibility and reduce the rate of inflation (Van den berg 2010). They enable economies to moderate their prices and wage expectations.
Their proponents believe that these exchange rates are stronger and will dominate the flexible regimes in time to come. However their effectiveness varies from country to country. There are those which will experience lower inflation as a result and others an ineffective nominal anchor.
Studies carried out show that in the 1980’s countries with fixed exchange rate experienced lower inflations than those with flexible rates. Today the rates of inflation in different states are very high and people are experiencing hard economic times. Studies carried out have proven that fixed rates raise the political costs of excessive monetary growth.
Flexible or floating exchange rates regime is determined by the demand and the supply of currency in the foreign exchange market (Yarbrough & Yarbrough 2006, p. 37). The exchange rate will be at the level whereby the demand and the supply of foreign currency are equal. Under this kind of regime, a rise in the market determined rate is called a depreciation of a fallen currency.
It becomes an appreciation if there is a rise in the price of the currency. On the other hand, fixed or pegged exchange rates are determined by the central banks of different countries (Yarbrough, & Yarbrough 2006, p. 38).
They do this by absorbing the excess demand or supply of a currency in order to maintain the pegged rates. The central bank of any given country plays a very crucial role in driving the economy of that country. It analyzes different issues in regards to the economy and determines the amount of money that should be circulating in the country.
It is possible for currencies to appreciate against other currencies and depreciate against others. For example the dollar may be stronger than other currencies but again it can be weaker than others. Therefore it is difficult to know whether a currency is generally appreciating or depreciating in foreign exchange markets. This necessitates the use of effective exchange rates.
For example if the dollar is used as the effective exchange rate it will provide a measure of all the dollar value relative to U.S trading partners’ currencies as a group (Yarbrough & Yarbrough, 2006, p. 42). Today, the dollar is used as the medium of exchange in various business transactions.
In fact, it is the most widely used currency in the world. Some states even use it to transact internal business activities. The use of the dollar as the standard measure makes international business easier as the cumbersome duty of carrying out different conversions is avoided.
Managed float regimes combines exchange rates determined by the market with a bit of foreign exchange market intervention (Yarbrough & Yarbrough, 2006, p. 322). This makes it able to combine the advantages of the fixed and the flexible exchange rates. The combination works towards preventing short term exchange rate fluctuations which may bring about uncertainty.
Market forces are therefore able to determine long run exchange rates and this enables them to avoid chronic payment disequilibria. However the use of this kind of regime may result to chronic balance of payment deficit if the adjustment mechanism is blocked. A change in the exchange rate or money stock is needed for the correction of a payment imbalance.
Fixed exchange rates impose price discipline by preventing central banks from carrying on excessive expansion. They reduce the uncertainty of exchange rate future value and all that brings about increased international economic activity and efficiency (Jongwanich 2006).
States with a balance of payment deficit will have reduced money stock as their central banks works towards avoiding the depreciation of the currency. It is the duty of the central bank of any given country to ensure that the states currency does not become weak compared to others. Most nations use the dollar as a measure of value to determine the strength of their currencies.
The central bank applies different strategies that aim at increasing the economic activities in that particular country. More so, any activity that would lead to international trade and hence bring in foreign currency is highly supported. Increased economic activity in any given country will automatically result to a better economy and a stronger currency.
There are problems that come with exchange rate volatility and uncertainty. They reduce international economic activity like trade and foreign investment. A reduction in this kind of activities will definitely have a negative impact on the economy of any given country. The domestic currency value of future foreign currency becomes less certain.
However other analysts are of the view that exchange rate volatility has got a less significant negative impact on international trade and investments. This is because there are forward markets that are available for hedging.
On the other hand, proponents of fixed exchange rates argue that a lot of costs may be involved in the process and forward contracts may not be available for currencies. Therefore it would be difficult to sustain foreign direct investments and other long term economic activities (Yarbrough & Yarbrough 2006, p. 331).
The shocks that are frequently experienced by different economies are highly determined by real exchange rates. This is because; the latter plays a very important role in microeconomic adjustments. Prevention of unilateral devaluations and evaluations enables a fixed rate regime to avoid the competitive devaluations that affected the economy during the great depression.
The world has experienced other minor depressions but this depression lasted for a whole decade and thus it came to be known as the great depression. The world felt the impact of this depression as it affected the economies of many countries.
Those who adopt fixed exchange rates regimes witness long periods of unemployment as a result of chronic failure to adjust to shocks. This is also fostered by the slow adjustments of price levels. This is what happened during the Bretton Woods period when the fixed rates regime started to decline (Jongwanich 2006). Devaluations did not take place frequently during this period and that was the main cause of the failure.
To correct the balance of payments disequilibria, the central banks should create favorable conditions and encourage the adjustments of money stocks. This will work towards enabling countries that make use of fixed rate regimes to avoid crises.
When exchanged rates are not adjusted, pressure builds up and that results to crises (Yarbrough & Yarbrough 2006, p. 332). The effects of the balance of payments should not be sterilized and there should be timely devaluation and evaluation. This will ensure the stability of exchange rates.
To avoid such crises governments may impose capital controls to limit the scale of payment imbalances but that can have a negative impact on the economy. Countries that adopt the fixed rates can only avoid crises if their policies convince the foreign exchange markets that there is no a forthcoming devaluation (Yarbrough & Yarbrough 2006, p. 333).
The use of flexible exchange rates ensures that there is the right kind of adjustments that will bring to the same level the quantity demanded and the quantity supplied. This avoids large balance of payments deficits and surpluses. When there are expectations of an impending evaluation build, this kind of rates can avoid the crises that are experienced when fixed rates are used.
Another advantage of the floating rates over the pegged rates is the fact that they can respond to all disturbances in the foreign exchange market. Countries that make use of the flexible rates are in a position to determine their own inflation rates (Yarbrough & Yarbrough 2006, p. 333). Therefore, they do not have to unwillingly accept the inflation rates that are chosen by the reserve currency country.
There has been a long standing debate on the most effective exchange rate. No conclusions have ever been drawn concerning the matter. However it can be concluded that some exchange rates are better than others as they bring about good macroeconomic results. For example, fixed rate regimes do bring about lower inflation compared to other regimes.
Every regime has got its negative and positive effects but what matters is which affects out do the other. If the negative ones are more than the positive ones, then the results could have more negative impacts on the economy. Inflation and growth are some of the macroeconomic targets that can be affected by the chosen exchange rates regimes (Van den berg 2010).
Therefore states are left to decide whether to make use of the pegged exchange rates or the flexible ones. For example, a commitment to the fixed rate regime may result to severe shocks which may not find avenues for accommodation.
It can also reduce the effectiveness of a particular stock of capital and undermine effective resource allocation. On the other hand, fixed exchange rate are said to foster investments by reducing policy uncertainties, exchange rate volatility and interest rates (Van den berg 2010).
Reference List
Gandalf, G 2002, International finance and open-economy macroeconomics: with 3 tables. Springer, Berlin.
Jongwanich, J. 2006, Capital mobility, exchange rate regimes and currency crises: theory and evidence from Thailand, Nova Science Publishers, New York.
Klein, M. W., & Shambaugh, J. C. 2010. Exchange rate regimes in the modern era, MIT Press, Cambridge, Mass
Van den berg, H 2010, International finance and open-economy macroeconomics: theory, history, and policy, World Scientific, Kuala Lumpar.
Yarbrough, B. V & Yarbrough, R. M 2006, The world economy: open-economy macroeconomics and finance, Thomson/South-Western, Mason, Ohio.