A fixed exchange rate Essay Example for Free

A fixed exchange rate Essay In the light of recent British economic experience, critically assess the view that allowing the pound to float is better for Britain than having a fixed exchange rate. The UK government can choose to fix or float the exchange rate. But what do these terms mean? Which method is better than the other? By defining what fixed and floating exchange rate systems are, and by using the recent experiences of the British economy, it is possible to shed a little light on the issues surrounding the control of exchange rates. A floating exchange rate system is a system of supply and demand for pounds. If, for example, the UK is in deficit due to excess imports from a particular country, then the pound should depreciate against the currency of that country. This happens because UK importers sell extra pounds on the foreign exchange markets in order to buy the other countrys currency to pay for those imports. Now there is an excess supply of pounds which lowers the sterling exchange rate. So, provided that the Marshall-Lerner elasticity conditions are fulfilled, the lower price of exports and the higher price of imports will, over time, improve the UK balance of payments. 1 The system should therefore regulate itself making it sustainable and leaving no pressure on reserves. A fixed exchange rate can take different forms. One is an adjustable peg system where the currency is pegged to another currency, but can be adjusted in small movements if necessary. Another is an independently fixed exchange rate where the UK would not allow any fluctuations. This policy would encourage investment but leave the currency open to speculation. The final form is that of monetary union which leaves exchange rate control in the hands of an independent central bank. The Euro is the most recent example of monetary union, and the debate as to whether Britain should join makes this topic extremely relevant. There are different measures of the exchange rate. Individual exchange rates or nominal exchange rates measure one currency against another, such as the i /$ or the $/i. This measurement is bilateral and does not take into account multilateral trade relationships. A more useful measurement is the effective exchange rate (EER) which takes an average value of a basket of currencies, which weights the relative importance of the currencies involved as trading partners for the UK. A measurement, which gives a stronger representation of UK competitiveness is the real exchange rate (RER or REX). This exchange rate takes into account the price of UK goods relative to the price of foreign goods and then multiplies it by the effective exchange rate. 2 There are a few arguments in favour of a fixed exchange rate. First, there are no significant fluctuations in the exchange rate under a fixed rate system. This adds stability to the economy as it reduces market uncertainty for potential investors. If they know that the value of their assets will not, in the foreseeable future, suddenly fall in value, then investment becomes a safer venture. Patrick Minford argues against this saying that the euro/dollar rate is very volatile and as a result it is even possible that our overall exchange risk would rise. 3 He also argues that a well managed country should not have much of a problem with exchange risk in general4 It is though, a strong point that a fixed exchange rate does increase security for investors. A fixed exchange rate also prevents against speculative currency attacks. They (monetary unions) can act to weaken the speculative instruments available in the capital markets for betting against the currency parities they are defending5 So a fixed currency prevents big money merchants from literally betting against a currency. Also prevented are the occurrence of competitive devaluations where a country deliberately undervalues its currency to boost its economy. An external exchange rate also creates the need for tight discipline within the domestic economy in terms of fiscal and monetary policy. 6 There are also disadvantages in having a fixed exchange rate. If exchange rates are controlled by an independent central bank then domestic control of the exchange rate is relinquished. This prevents the manipulation of the exchange rate during times of particular need, and makes asymmetric shocks harder to deal with. If the UK is in recession and the rest of the Euro zone is not, then its recession may last longer and deepen because interest rates cannot be lowered7 This will result in a fluctuations in unemployment, output and prices that are much greater than if the exchange rate is flexible. This makes the adjustment process long lasting and more painful. One advantage of a floating exchange rate is that it is self-adjusting. If a currency is valued too highly then, exports decrease, imports increase and currency flows out of the country and the rate of exchange falls. If the currency is too low then the reverse happens. So any imbalances are able to automatically correct themselves via the exchange rate. Not being tied in to a fixed exchange mechanism allows for freedom of internal economic policy as we mentioned previously. The opportunity for large scale speculation may be reduced as rates are allowed to move up and down without restriction. This in turn means that a country has less need for reserves. The disadvantages of a floating exchange rate are: an increased uncertainty for traders which may lead to less investment; the threat of price instability through increasing import prices; and, a floating exchange rate may actually encourage speculation through co-ordinated buying and selling of sterling. The recent economic performance of the UK can be used to can evaluate the effect of a fixed or floating exchange rate as both methods have been used. Between 1990-1992, the UK entered into the exchange rate mechanism (ERM) which fixed the sterling against other Euro currencies. Unemployment rates, GDP levels and export volumes can all be used as indicators of the UKs economic performance during this period. Below is a table which shows indices for export volumes, unemployment rates and the average exchange rate against sterling during the period of 1979-2000. Table 1. Export, Unemployment and Exchange Rate Indices 1979-2000 1990=100 Year Exports Unemployment rates Average rates against sterling Source: www. statistics. gov. uk/Statbase National Statistics Website Actual figures: Authors own work Fig. 1 further illustrates these figures. Fig. 1 Fig. 1 shows that between 1979 and 2000, exports rose at a fairly constant rate with a slight halt in 1985. From Table 1, unemployment rates have varied during the same period from a high of 11. 9% in 1984 to 5. 7% in 2000, but have remained in what is a relatively small band compared to the exchange rate. The exchange rate has had the greatest variance, ranging from 127. 8% to 84. 8% of the base year, falling rapidly from 1981 until 1995 with a slight reprieve in 1987. During the ERM years between 1990 and 1993 we can see some definite trends in both unemployment and the exchange rate. Between 1990 and 1993 unemployment rose by 3. 6%. Following the UKs exit from the ERM, unemployment fell again and has continued falling until 2000. The unemployment figures are interesting as they seem to have a cyclical pattern. Did the fixing of the exchange rate increase unemployment or was this the result of the trade cycle? There is evidence that it was not due to the trade cycle. The UKs pattern of unemployment rates which are typically akin to those of the US, differed greatly at this time. Between 1990 and 1993 the increase in UK levels of unemployment is much larger than that of the US. The UK level of unemployment rose 4. 4% between 1990-93 whereas the US level only rose 1. 3%. US levels actually fell between 1992 and 1993 when UK levels rose. 8 It was not a period of cyclical unemployment that caused the unusually large increase in unemployment. One other argument is that the Lawson Boom of the late 1980s, and the inability to sustain such growth, may have in increased unemployment in the early 1990s. The exchange rate as we know remained constant between 1990 and 1992, which can be seen in Fig. 1. What is interesting, is the effect of the UK leaving the ERM on the exchange rate. The 1993 floating exchange rate is 8% lower than the previous year when the rate was fixed and stayed low until 1997 when the New Labour government came to power. This tells us that the natural level of the sterling exchange rate was lower than its fixed rate within the ERM. The level of economic growth (measured by GDP) also deviates from the norm between 1990 and 1993. Growth was slower in this period as can be seen in Fig. 2 below. Fig. 2 It could be argued that this was an after effect of the Lawson Boom of the late 1980s rather than the UKs membership of the ERM. The trend is similar for export levels. If we take a closer look at Fig. 3 below, there is a slowdown in the growth of UK exports during the time that the UK was a member of the ERM. Fig. 3 On exiting the ERM in late 1992 the volume of exports increased at a rate faster than any time previously. It is likely that the increase in exports was caused by the low value of the pound after it was forced out of the ERM. The lower-valued pound makes UK goods relatively cheaper than goods of other countries, and encourages foreign buyers. So, when the pound is fixed at a value above its natural level it can have an adverse effect on the level of exports. Another reason why export volumes may have decreased, could be due to an increase in domestic prices which is a sign of a growing economy. So it could be argued that the whilst the Lawson boom increased the wealth of the economy, at the same time it had a negative effect on the level of UK exports. There is certainly some evidence then that being attached to a fixed currency can have a negative effect on unemployment, export volumes and GDP. This evidence though, is inconclusive as the data from the key period is clouded by another historic economic event, the Lawson Boom. Patrick Minford argues that, fixed exchange rates can work given a number of characteristics within the monetary environment. These characteristics are: symmetric industries, automatic stabilisers, freedom of movement of labour and flexible wages. 9 However, these conditions are not met within the Euro zone. There are advantages in belonging to a fixed exchange rate system but currently the disadvantages leave a serious doubt over whether it is the better option. The sacrifice of monetary and fiscal policy must be compensated for with significant gains in economic security. There are doubts as to whether a fixed exchange rate system is better than a floating system. If a fixed rate system is joined, then it is imperative that it is joined at the right rate or the problems of the ERM will re-surface and Britain may suffer for many years to come. Even if it is joined at the right rate, over a lengthy period of time that correct rate is likely to change. Bibliography 1. Griffiths A Wall S (1997) Applied Economics 7th Edition. Longman, London 2. Curwen P (1997) Understanding the UK Economy. Fourth Edition, Macmillan, London 3. Patrick Minford (2002) Should Britain Join the Euro Institute of Economic Affairs Occasional Paper 126 4. Will Hutton (1997) The State Were In Vintage. 5. National Statistics Website www. statistics. gov. uk/Statbase 6. OECD Economic Outlook Volume 2002/2 No. 72 December 1 Griffiths and Wall p. 625 2 Curwen, Understanding the UK economy p. 599 3 Patrick Minford, Should Britain Join the Euro (Institute of Economic Affairs 2002) p. 25 4 Patrick Minford, ibid. p. 31 5 Will Hutton, The State Were In (Vintage 1996) p. 316 6 Griffiths Wall p. 626 7 Patrick Minford, ibid. p. 43 8 OECD Economic Outlook Volume 2002/2 No. 72 December, Annex Table 14: Unemployment rates: commonly used definitions 9 Patrick Minford, ibid. p. 43.