Floating Exchange Rates applications, significance and impact on economic growth

Floating Exchange Rates’ applications, significance and impact on economic growth

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Introduction

Financial stability and currency values are very important issues that need to be given special attention and recognition by every country in the process of developing, coordinating and implementing macroeconomic policies. By coming up with sound and accountability oriented policies with respect to fiscal and monetary management, the governments become a very important institution as far as issues relating to international finance and international trade are concerned. It is with this respect that the floating interest rate regime has been applied to help in the management, control and regulation of international finance and national currencies. Floating /flexible exchange rate regime entails a macroeconomic money regulation system where the market forces dictate the rates or currency prices. Thus, the rate at which one currency may be sold or traded against another is not rigidly / subjectively determined by the regulators but the interaction between the demand and supply in the foreign exchange market. As such there is neither a static nor predetermined currency exchange rates. This paper discusses the concept of flexible exchange regime as applied by different countries to ensure non discretionary and subjectively determined exchange rates. There is also critical review of the impact that the flexible exchange has in an economy more so with respect to economic growth and enhancement of development and net exports. The paper also outlines the challenges that are faced in the process of application of flexible exchange rates regime in a bid to implement macro economic policies.

Floating Exchange Rates: Description

Descriptively, the flexible exchange rate regime allows for free fluctuation of the exchange rate without interference by the authorities such that the government does neither have an exchange rate control policy nor impose a predetermined exchange rate.

Wide application of the floating exchange rate in the economy can be traced to the 1970s. By 1980s, most countries had adopted this system as the best way to deal with macro-economic challenges that require a more proactive and indirect intervention by the regulators and a way of managing / controlling the speculative exposures that an economy may experience under the fixed exchange rate regime. A major shift in the exchange rate system that led to wide application of the flexible exchange rate came in 1990s when it became apparent that a country had to choose one of the regimes (Kenen, 2000).

Debate among the proponents and opponents of the system of currency rate management have always revolved around the dangers and benefits of the free fluctuations of the exchange rates in the economy. Though the flexible exchange rate regime allows for free movements of the currency prices, the opponents of the system have cited this as a weakness that is akin to economic instability as well as exposures to dangers of economic fluctuations. However, the principle behind the adoption of the flexible exchange has it that the economic fluctuations or changes in the rates of exchange will not be erratic. The significant benefit of this regime is that it enhances national autonomy with respect to monetary issues. As such every country can effectively design the policy instruments that are consistent with their macro economic objectives.

Impact on the Economy

A fundamental question with regards to the role and choice of the type of the regime to adopt would normally be based on the understanding of how the choice made would affect the domestic economy’s growth and development. The flexible exchange rate regime is preferred because of the impact that it has to the economy and influence on the economic growth. Generally, the flexible exchange rate regime has both direct and indirect impacts on an economy. First, under the direct effect, it is held that the flexible exchange rate regime helps an en economy to recover from shocks. Generally, this type of regime has better economic shock insulation as compared to the fixed regime. This argument is supported by Broad (2002) who observed that under the fixed exchange rate regime, due to unfavorable trade balance, a country would experience a huge fall in real GDP figures due to small magnitude currency depreciation as well as fall in price levels . On the other hand, adoption of floating exchange rate regime, experience a relatively smaller magnitude of real GDP fall and high level of currency depreciation, under similar circumstances. However, this argument holds in the short run as in the long run, both regimes show similar behaviors.

By making implementing macroeconomic polices that are well fused with the macro economic objectives and the flexible exchange rate; it is possible to have direct impact on the economy through growth. This system offers the best adjustment to the economic shocks as it is more responsive and fast reflected in the foreign exchange market. This argument is based on the fact that the other sectors that may help in stabilizations such as the labor market do not respond fast to market changes as the foreign exchange currency rates. Similarly, the Treasury (2010) argues that the flexible exchange rate system has been preferred by several countries as it has been viewed to offer “better able to absorb shocks from open capital markets than economies with a pegged rate”. Through the possibility of independence in designing and application of monetary policies, it is likely that the nominal market rigidities can be dealt with effectively.

Based on economic theory, the floating exchange rate regime has some indirect influence on the rate and pace at which an economy grows. The ways in which the flexible exchange rate regime may influence the rate of economic growth is through impacts of investment levels, the composition and nature of the international trade and the pace and well as efficacy of the financial market. Generally, the flexible exchange rate regime has an indirect impact on economic growth. This is mainly in terms of the investment by the foreigners. Though the fixed exchange regime is desired as it encourages stability and certainty, there are certain arguments which favor flexible exchange rates in relations to international investments. The fixed exchange regime has been cited as a god foreign investment attraction model as it keep both the rates of interest and inflationary pressures low. This would encourage borrowing and consumption as well as exports. However, flexible exchange regime has been described as favorable to foreign investors who are risk takers and ready to invest in a foreign market based on possibility of non erratic exchange rates. The flexible exchange rate regime is favored in this respect as the fixed exchange may be abused, or used selectively to perpetuate protectionist policies. This way, the flexible exchange rate regime is depicted as a macro economic policy that encourages globalization and foreign investments on the account that the system is not open to political abuse or arbitrary determination of exchange rates, but it is the market forces that reflect the prices of currencies.

The flexible exchange rate regime also promotes economic growth and development in an indirect manner through enhancement of development of the capital money markets. With a poorly developed financial market, it is not possible for an economy to recover fast from economic shock. However, adoption of flexible exchange rate regime will promote need for competitiveness in the financial markets so as to attract foreign investors in a country’s bourse. This is because, for a floating exchange rate to work effectively, there s need for high level of transparency and objectively strong regulation of the financial market. The transparency in the management of the exchange rate would have a trickle down effect on other sectors, notably the financial market. As such, a country’s competitiveness will improve as indicated by the level of capital inflows and foreigner’s investment in financial securities due to high level of investor confidence.

Influence to Economy

The significance of the type of exchange rate regime chosen by a country may have to an economy has been a point of debate among many researchers. According to Pedreski (2009), taken nominally, an exchange rate has no major influence on economic growth, particularly in the long run. At the same time the author argues that this question has been ambiguously handled with little clear theoretical evidence offered. However, the type of an exchange rate regime chosen, that is flexible or fixed, will affect the economic growth. Impliedly, a floating exchange rate regime may affect the economy and the rate of economic growth through the impacts it has on “trade, investment and productivity” (Pedreski, 2009).

Because of the reduced level of foreign exchange reserves that the central banks need to keep and allowing of market forces to operate freely in the foreign exchange markets, the flexible exchange regime allows for development of monetary polices that can enhancement of certain macro economic objectives. Generally, adoption of the flexible exchange regime boosts international trade, globalization of the financial system and removes risk exposures that come about from currency speculations. This is what Kenen (2000) refers to as “vulnerability to speculative attacks”. This system also promotes independence of the monetary regulatory authorities in different countries so that the process of monetary control is done objectively and professionally. By adopting the flexible exchange regime, a country stands to benefit from sound monetary management, applications of customized macro economic polices that suit a given domestic economic setting.

Several macro economic objectives can be achieved through the flexible exchange regime without much intervention of the central banks. These objectives are normally aimed at promoting productivity and economic growth. One of the main macro-economic objectives is management of export and import net flows so that a country’s development and competitiveness is not hampered by the exchange rate fluctuations and imbalance in the balance of payment account. Trade deficit is normally a non favorable economic indicator. Under the fixed exchange rate regime, to deal with such deficits, the central banks normally use the foreign reserves. This process is expensive and may not immediately spur economic growth. However, under the flexible exchange regime, it is partially possible to allow the market forces to bridge a trade deficit. This occurs where the monetary policy adopted is to enhance money velocity locally so that demand and productivity increases while at the same time export promotion strategies are in place.

The flexible exchange regime would help to achievement these objectives and ensure stabilization in a disequilibrium state. Because of the trade deficit, the foreign currency price (exchange rate) will be forced down. This will help to make the exports relatively cheap while the imports will be more costly. As the exports become more expensive, the demand will fall while the foreign markets will demand more of the exports to enable a country earn more foreign income. In the process, the fundamental disequilibrium situation will be solved and the surging deficit abridged.

Broadly, the changes in the labor market in terms of demand and supply are affected by the kind of exchange rate regime in place. In turn, the situation in the labor market influences the pace and magnitude of the economic growth. Any sector that operates in the international market will feel the effect of currency fluctuations. Thus, it is critical that the monetary policies adopted seek to ensure high output and stability in the labor market. To understand how the currency exchange rate changes affect the labor market, it is important that the relationship between exchange rate changes and labor market be outlined. With a rise in the exchange rate that makes one currency stronger than the other, it is likely that growth Gross Domestic Product, in real terms, will stagnate. This is because; the appreciation in a local currency will greatly affect exports in a negative way. Consequently, the local producers may react to the fall in demand for the products for export markets by scaling down their operations and carrying out retrenchments.

However, through flexible exchange regime, the regulators may act by promoting availability of credit to the business so that the collapse of strategic industries does not take place. This will make the economy have higher money supply. At the same time, when the exchange rate is strong, it is possible that with the increased money supply, the economic stability and recovery may be possible. According to Markin (2003)., when the central banks increase the real money supply in the economy, the prevailing rate of interest will fall in the domestic market, thus enhancing economic growth The rate of economic growth that comes with such sound macro economic polices under the flexible exchange rate regime emanates from the fact that lower interest rates in the domestic markets lead to increase in the consumptions well as investments locally. Based on this argument, the flexible exchange rate regime allows for economic growth given that with the fall in the price levels in the local market, the wealth created act as inducement for expenditure and investments by the households and the private sector.

Benefits to the Economy

Several factors and economic explanations have been put forward to underscore the b benefits that can accrue in an economy that has adopted and fully implemented the principles of floating exchange rate regime. Through the flexible exchange rate system, it is easier for the regulators to influence money velocity, demand and supply in an easier and freer manner. With a free and less rigid money regulation, the central bank will be able to engineer and stimulate economic growth due to possibility to apply target monetary control principles on specific variables to achieve a given objective that suits a particular economy. Put differently, this macro-economic system enables the central bank to pursue a country specific monetary policy. This however requires a high level of fiscal and monetary discipline and non political interference in the momentary policy development and applications. As such the central bank will be able to check the rates of interest rate changes as well as the inflation levels.

The concept of currency competition supports the benefit of non fixed exchange financial regime. This is because there is no control of the prices in the market. This differs from the rigid system where the central banks act as the only suppliers in the market. As only suppliers, they are able to dictate the prices thus promoting unfair competition.

Application of the floating exchange rate has gained wider application because of the fundamental benefits that comes with the system, based on the economic indicators. The fixed regime had certain issues with regards to economic lags. This is because; it is the economy that responds to the pegged currency prices. On the other hand, the non discretionary monetary system, the currency prices adjust with the volumes and nature of market trade thus giving a picture/ reflection of the status of the economy.

Through the pursuit of independent monetary policies, it is easier for the regulators to influence resources distribution fast and efficiently. The regime is less susceptible to economic shocks thus helping in a more objective distribution of the spill-over of market shocks between local and foreign economies. According to Pedreski (2009), flexible exchange rate regime has an effect open the economic shock adjustments as sound management of the process may help design effective strategies to absorb the shocks.

The application of the flexible exchange rate also limits need to have more reserves which can be used in market stabilization. This is because, the principles of flexible exchange rate regimes do not advocate for keeping of foreign reserves that can be used for market intervention. This makes it easier to fully apply the monetary policies to meet such objectives management of employment and inflation rates. Through the self adjustment mechanism, the central bank will have to concentrate in other macroeconomic objectives as the exchange rate will be ‘self adjusting’.

Additionally, the application of the flexible regime offers the best way to ensure faster adjustments to the prevailing economic situations. The economic adjustments however depend on the currency exchange rate movements. During currency depreciation against a stronger one, for instance, the demand for export improve thus promoting export trade, production and economic growth. However, this can only happen if the net export gains are not eroded by the other cash outflows such as increase in wage rate and rise in export prices. Nevertheless, the research findings by show that if bilateral trade figures are analyzed objectively, then it would be would be realized that net flows drawn from the nations that has adopted the flexible exchange regimes would be relatively high, as compared those which do not have such policies (Brada & Mendez, 1988 ).

Challenges

Though the flexible exchange rate regime has been overly described as the best way to enhance a country’s competitiveness in the global market, certain fundamental challenges have been experienced with its applications. The policy challenges of this regime became more serous during the recent credit crunch. As such there have been calls for more innovative international trade management as well as development of intervention strategies that would help in handling the target variables. The general argument has been that the market is efficient and has self adjusting mechanisms. However, the financial crisis exposed weaknesses of the flexible exchange rate regime more in relations to international trade that is fast becoming very interlinked and responsive globally. The major challenges posed by the flexible exchange rate regime is how a country can deal with the spill over of credit crunch that is taking place in another market with which it trades. Another challenge comes about from the fact that most international trade instruments and transactions are voiced in major currencies like the USD, Euro and Yen. This way, the market failures in US, Europe or Japan will automatically be felt globally. Further, the flexible exchange regime results into such challenges as market uncertainties as well as irregularities in flows of capital into and out of an economy. Further,

Selcuk (2005) argues that with the flexible exchange regime it is very challenging for the authorities do contain market volatility. Countries like Turkey had to resort to auctioning of currencies periodically to manage their market precariousness (Selcuk, 2005).

Conclusion

From the discussion, it is evident that the flexible exchange rate enhances transparency, promotes trade and investments as well as the level of production. However, the focus should be how a country can effectively apply the regime without undue interference by the authorities. To ensure economic stability, it is desirable that the authorities manage the short run effects of the exchange rate movements so as to allow the economy to absorb the shock before their effects escalate. This requires what Selcuk (2005) describes in the case of Turkish economy as “structural reform process and pursues sound fiscal policies that would held bring down public debt as well as debt ratio, without which adverse shock may erode the gains made The governments should also have in place effective macro economic objectives and policies as well as target variable that guide international trade.

References

Brada, J. & Mendez, J (1988). Exchange Rate Risk, Exchange Rate Regime and the Volume of

International TradeWWZ and Helbing & Lichtenhahn Verlag AG.

Broad, C. (2002). Terms of Trade and Exchange Rate Regimes in Developing Countries. Federal

Reserve Bank of New York Staff Report Number 148.

Kenen, P., B. (2000). Fixed Versus Floating Exchange Rates Cato Journal, Vol. 20, No. 1.

Markin, A. (2001). Macroeconomic Policy in an Output-Expenditure Model. IAER Journal, Vol.

7, No. 3.

Pedreski, M. (2009). Exchange-Rate Regime and Economic Growth: A Review of the

Theoretical and Empirical Literature. Staffordshire University. Economics e-Journal, No. 31.

Selcuk, F. (2005). The Policy Challenge with Floating Exchange Rates: Turkey’s Recent

Experience. Open Economies Review.

Treasury (2010). Fixed vs. Flexible Exchange Rates. Retrieved June 18, 2010, from

HYPERLINK “http://www.ustreas.gov/offices/international-affairs/economic-exchange-” http://www.ustreas.gov/offices/international-affairs/economic-exchange-rates/pdf/Appendix_2.pdf.