1. An exchange rate is the price of one currency expressed in terms of another. If the U.S. exchange rate for the Canadian Dollar is $1.60, this means that 1 American Dollar can be exchanged for 1.6 Canadian dollars.
With a high exchange rate, there are many advantages: Imports become relatively cheaper. For example the price for imported raw materials becomes cheaper; the cost of production for firms becomes less. This could lead to decreased prices for consumers. The lower price of imported goods also puts pressure on domestic firms to keep prices low. All this leads to a downward pressure of inflation. Furthermore, more imports can be bought. A high exchange rate means that for each unit of the currency, more units in foreign currencies can be bought. Therefore there will be more visible imports, such as technology, and invisible imports, such as foreign travel. Moreover, a high value of currency forces domestic producers to more efficiency as they will try to remain their competitiveness. This would lead to greater economic productivity of the country.
Yet, a result might also be the laying-off of workers. As visible, there are also disadvantages to a high exchange rate. Export industries might be damaged. Domestic companies will find it hard to sell their products abroad due to their relatively high prices, which could lead to unemployment in these industries. There also might be damage to domestic industries. As it is cheap for households to consume products from abroad, domestic industries might find that the demand, defined as the quantity of goods and services that consumers are willing, and able to buy at each possible price over a given time period, for domestic product falls. A result of this might be further increase in the level of unemployment, defined as the people of working age, those in the labour force, actively seeking work at the current wage rate but cannot find one, as firms cut back.
Possible advantages of a low exchange rate involve the greater employment in export industries as exports become relatively less expensive. Furthermore, domestic companies might experience greater employment as the low exchange might encourage consumers to spend more on domestic goods and services, rather than importing goods and services. This might also raise employment. A possible disadvantage of a low exchange rate is inflation, defined as the sustained increase in the general or average level of prices. Imported final goods and services, raw materials and components become more expensive. The cost of production for firms will rise, leading to a raise prices for the final products.
To sum up, a high exchange rate may be a good fight against inflation, but unemployment could be created, whereas a low value of a currency may be good for solving unemployment problems, but may create inflationary pressure.
2. A fixed exchange rate is an exchange rate regime where the value of a currency is fixed to the value of another currency, to the average value of a selection of currencies, or to the value of some other commodity, such as gold. Usually the central bank or government decide upon and maintain the value of the currency.
The Barbadian Dollar has been fixed against the US dollar at a rate of 2Bds$ = 1 US$ since 1975. When there is an increase in supply, defined as the willingness and ability of products to produce a quantity of a good at a given price in a given time period, for Barbadian dollar, for example due to the Barbadians purchasing a greater amount of imports, the supply curve shifts from S1 to S2. There is excess supply of Barbadian dollars from Q2 – Q1. Without intervention by the government, the exchange rate would fall, leading to inflationary problems. The government will then buy up the excess supply of its own currency on the foreign exchange market. This shifts the demand curve from D1 to D2. This is possible due to previously amassed reserves of foreign currencies.
An advantage of such a fixed exchange system is the reduction of uncertainties for all the economic agents in the country. Firms will be able to plan ahead, knowing that the predicted costs and prices for international trading agreements will not change. Furthermore, fixed exchange rates ensure sensible government policies on inflation as inflation has a very harmful effect on the demand for exports and imports. The government is forced to take up measures to ensure a low level of inflation. In theory, a fixed exchange rate should also reduce speculation in the foreign exchange markets. Yet, this has not always been the case in the past.
Disadvantages of a fixed exchange rate are that the government is compelled to keep the exchange rate fixed. The main way of doing this is through the manipulation of interest rates. However, if the exchange rate is in danger of falling, then the interest rates have to be increased to raise demand for the currency. This will have a deflationary effect on the economy, lowering demand and increasing unemployment. Furthermore, high level of reserves need to be maintained to make it clear that it is able to defend its currency by the buying and selling of foreign currencies.
Setting the level of the fixed exchange rate is not simple. If the rate is set at the wrong level, export firms may find a lack of competitiveness in foreign markets. In case of that, the exchange rate needs to be devalued, but again, finding the exact right level is difficult. Furthermore, a country that fixes its exchange rate at an artificially low level may create international disagreement. This is because a low exchange rate will make the country’s exports more competitive on world markets and may be seen as an unfair trade advantage. This may lead to economic disputes or to retaliation.
An advantage of a floating exchange rate is that it does not have to be kept at a certain level. Interest rates are free to be employed as domestic monetary tools. It could be used for demand management policies. An example for this would be controlling inflation. To keep the current account balanced, the floating exchange rate should adjust itself.
For example a current account deficit, the demand for the currency is to low since export sales are relatively low. The supply of the currency is high, since the demand for imports is relatively high. As you can see, markets adjust and the exchange rate should fall. Export prices become relatively attractive, import prices relatively less attractive and the current account balance should settle itself. Another advantage is that reserves are not used to control the value of the currency. This makes is unnecessary to keep high levels of foreign currencies and gold.
There are also disadvantages. Uncertainty tends to be created. Planning of businesses tends to be difficult and investments, defined as the expenditure by firms on capital equipment and is an injection into the economy, are hard to assess. The levels of international investment will decrease. Furthermore, in reality, floating exchange rates are affected by many factors, not only demand and supply.
Another factor would be speculation. Therefore they might not adjust themselves and might not eliminate current account deficits. Last, a floating exchange rate regime may worsen existing levels of inflation. High inflation relative to other countries will make its exports less competitive and imports will be relatively less expensive. Yet, this could lead to even higher prices on import goods and services and inflation.