Question

Is a country for which imports and exports comprise a large fraction of the GDP more likely to adopt a flexible exchange rate or a fixed (hard peg) exchange rate?

Short answer

A country with large imports and exports as a percentage of GDP is more likely to adopt a flexible exchange rate. This is because a flexible exchange rate system allows for automatic adjustments in exchange rates, independent monetary policy, and reduced vulnerability to speculative attacks. On the other hand, a fixed exchange rate system has disadvantages like loss of monetary policy independence and vulnerability to speculative attacks which may outweigh the benefits in the context of a country with significant trade volumes.

Step-by-step solution

Understanding Flexible and Fixed Exchange Rates

Flexible exchange rate system, also known as a floating exchange rate system, refers to a system where the exchange rate of a country's currency is determined by market forces, i.e., supply and demand for the currency. In this system, central banks may intervene occasionally but generally allow market forces to dictate the exchange rates. Fixed exchange rate system, on the other hand, refers to a system where the government or the central bank of a country fixes the exchange rate of its currency against another currency, usually a major reserve currency like the US dollar or the euro. In this system, the central bank stands ready to buy or sell its currency at the fixed rate, ensuring that the rate remains unchanged. Now, let's compare these systems for a country with large imports and exports as a percentage of GDP.

Advantages of a Flexible Exchange Rate System

For a country with large imports and exports as a percentage of GDP, a flexible exchange rate system has the following advantages: 1. Automatic adjustment: The exchange rate can automatically adjust to offset changes in trade surpluses or deficits, which can help to maintain a balanced current account. 2. Independent monetary policy: The country has the freedom to pursue its monetary policy, such as adjusting interest rates to control inflation or boost economic growth, regardless of the impact on the exchange rate. 3. Reducing speculative attacks: In a flexible exchange rate system, since the central bank does not defend a specific exchange rate, speculative attacks on the currency are less likely.

Disadvantages of a Flexible Exchange Rate System

For a country with large imports and exports as a percentage of GDP, a flexible exchange rate system has the following disadvantages: 1. Exchange rate risk: Companies and importers/exporters face exchange rate risk, as the exchange rate can fluctuate daily, which makes it harder to predict the costs and revenues associated with international trade. 2. Inflation imported: A depreciation in the exchange rate can lead to higher import prices, which may, in turn, lead to inflation.

Advantages of a Fixed Exchange Rate System

For a country with large imports and exports as a percentage of GDP, a fixed exchange rate system has the following advantages: 1. Reduced exchange rate risk: By fixing the exchange rate, the central bank reduces the exchange rate risk faced by importers, exporters, and investors, allowing them to plan their financial activities more securely. 2. Price stability: A fixed exchange rate system may lead to greater price stability, especially if the country's currency is pegged to a stable currency with low inflation.

Disadvantages of a Fixed Exchange Rate System

For a country with large imports and exports as a percentage of GDP, a fixed exchange rate system has the following disadvantages: 1. Loss of monetary policy independence: A country with a fixed exchange rate system may have to prioritize maintaining the fixed exchange rate over its monetary policy objectives, which may not be optimal for the economy. 2. Vulnerable to speculative attacks: In a fixed exchange system, the central bank has to defend the fixed exchange rate, which may make it vulnerable to speculative attacks if market participants believe the central bank may not be able to maintain the peg. After considering the pros and cons of both exchange rate systems for a country with large imports and exports as a percentage of GDP, we can conclude that a flexible exchange rate system is more likely to be adopted by such a country. This is mainly due to the ability of a flexible system to automatically adjust the exchange rate, reducing the need for central bank intervention and allowing for independent monetary policy.