Question

Essay question 'Capitalist firms have no problem prospering despite the volatility of stock markets. Nobody has ever suggested government policies to fix stock market prices. Exchange rates are just another asset price and it is just as silly to fix exchange rates. Let them float.' Why do governments ever want to fix exchange rates?

Short answer

Governments fix exchange rates to ensure economic stability, control inflation, boost business confidence, and potentially gain political and economic alignment advantages.

Step-by-step solution

Understanding the Role of Exchange Rates

Exchange rates are the price of one currency in terms of another and fluctuate based upon supply and demand dynamics in foreign-exchange markets. The exchange rate affects trade balances, pricing of goods, and international investment flows.

Identifying Reasons for Fixed Exchange Rates

Governments might fix exchange rates to maintain stability in international prices, which reduces exchange rate risk and uncertainty in international trade. This can encourage more international trade and investment by providing a stable economic environment.

Reviewing Economic Stability and Inflation Control

By fixing exchange rates, governments can achieve greater economic stability, minimizing fluctuations that might lead to economic downturns. A stable exchange rate can also help control inflation, as it limits the price variation of imported goods.

Analyzing Impact on Business Confidence and Investment

A fixed exchange rate regime can boost business confidence, as firms can make long-term plans without worrying about currency instability. This can promote more widespread international investment by reducing perceived economic risks.

Considering Political and Economic Policy Alignment

Political considerations may also drive the desire to fix exchange rates, especially in countries seeking to align with economically stronger or stable countries. By pegging a local currency to a major one, countries might gain favorable economic standing and political leverage.

Key concepts

Fixed Exchange Rates

Fixed exchange rates involve setting the value of a country's currency directly to another major currency or a basket of currencies. This is done by the country's government or central bank at a specific rate.

There are several reasons why a government might choose to impose fixed exchange rates. A primary motivation is to provide predictability and stability in the economy:

• Predictability: With a fixed rate, businesses and investors know exactly what to expect in terms of currency value when trading with other countries, which helps in long-term planning.
• Stability: It reduces the uncertainty in transactions, especially those involving exports and imports, by ensuring that exchange rates do not fluctuate too rapidly or unpredictably.

Moreover, fixed exchange rates can ease the process of trade between the pegging country and the currency it is pegged to, potentially boosting economic ties and partnerships.

Economic Stability

Economic stability refers to a state where an economy experiences constant growth with a low level of fluctuation in terms of inflation, employment, and other economic indicators.

A fixed exchange rate can contribute significantly to economic stability. Here's how:

• Minimizing Exchange Rate Volatility: By fixing the rate, countries can avoid sudden and disruptive changes in exchange rates that can impact international goods and services pricing.
• Prevention of Speculative Attacks: Currency speculation can create sharp and destabilizing currency fluctuations. A fixed rate can ward off such speculation by maintaining set exchange rates.

When there are fewer fluctuations, the economy can grow steadily, and policymakers can focus on long-term strategic stability rather than short-term firefighting against currency instability.

International Trade

International trade refers to the exchange of goods and services across international borders. It is a pivotal component for most economies as it allows countries to access resources they don’t have and sell goods to international markets.

Fixed exchange rates can have several benefits for international trade:

• Reduces Exchange Rate Risk: Businesses can trade internationally with less concern about loss from exchange rate movements.
• Stable Pricing: Importers and exporters can maintain stable pricing strategies since they are not caught off-guard by unpredictable currency swings.

Overall, by providing a dependable rate, fixed exchange rates can lower barriers to trade and help businesses penetrate new markets with confidence.

Inflation Control

Inflation control is crucial for maintaining the buying power of a currency and ensuring that an economy does not overheat with rapidly rising prices.

Fixing exchange rates can aid in curbing inflation by:

• Achieving Price Stability: When the exchange rate of a currency is stable, the cost of imported goods also remains stable, thus avoiding a pass-through effect of exchange rate fluctuations on domestic prices.
• Import Price Beneficence: Countries that rely heavily on imports can maintain affordable prices for goods, which are vital for consumers and industries.

By controlling inflation through stable exchange rates, economies can maintain healthy growth and protect consumers from volatile price changes.