Describe the difference between fixed and flexible exchange rates
Fixed exchange rates refer to the predetermined nominal rates of exchange that are arbitrarily set by a government. To this end, a government, through a fiscal monetary policy organ such as a central bank, issues the thresholds for the permissible exchange rates applicable for a given duration regardless of the prevailing conditions in the foreign exchange markets (Stone, 2008). Flexible exchange rates, on the other hand, are rates of exchange that fluctuate perpetually relative to the supply and demand dynamics of the foreign exchange markets (Stone, 2008).
Therefore, the main difference between the two is that fixed exchange rates are manifestations of economies that are tightly regulated by governments while flexible exchange rates are manifestations of the liberalized and free-market economies (Stone, 2008). Moreover, whereas fixed exchange rates are usually imposed as blanket solutions to stem inflation, flexible exchange rate regimes employ selective fiscal mechanisms that are relative to the prevailing economic circumstances at given times, to put inflation into check.
Trace through the reasoning why monetary policy is enhanced by a flexible exchange rate system
Monetary policy is enhanced by a flexible exchange rate system because it seeks to address the root problems, that is, the prevailing deficits and discrepancies in international trade. Rather, it is the flexible exchange rate systems that shape monetary policy and not the other way round. Indeed, monetary policy focus is always shifted towards exchange rates whenever an economy is hit by currency-instigated inflationary trends (Stone, 2008).
The eventual deficits in the balance of payments, that results from the value of imports exceeding those of exports, is what triggers inflation. More catastrophic is the fact that the demand for foreign-denominated currencies required to pay for imports increases effectively outstripping the supply of foreign currency. This brings about consequences of stagnation and eventual declines in economic growth when economic inflation hits phenomenal levels.
In a liberalized economy, appropriate policy intervention measures must be adopted to halt further growth of inflation. However, unlike fixed exchange rate systems that seek instant solutions to inflation by imposing ceilings on exchange rates, flexible exchange rate systems seek to gradually halt inflation by employing time-based solutions that are relevant to the prevailing circumstances in the foreign exchange markets (Stone, 2008). This means that monetary policy interventions cuts across the analyses of all the relative fiscal parameters that concern international trade intending to strike a balance between imports and exports to address deficits in the balance of payments.
At this point, it becomes imminent that the monetary policies that are initiated by a country’s central bank at a particular time are dependent upon the prevailing exchange rates and economic inflation conditions at the given time. This occasions the selective application of policies that will ease the demand and shore up the supplies for foreign currencies. Such mitigating policies may include sweeping excess liquidity of the local currency by increasing the base lending rates (Stone, 2008).
When the central bank’s base lending rates are high, commercial banks will consequentially increase their interest rates in a move that would discourage borrowing for import purchases of expensive and non-essential items. The suppressed liquidity effectively reduces imports and shifts the driving parameters of international trade back towards a degree of normalcy.
When the world’s economies are on a fixed gold standard and the discoveries of gold do not keep pace with the growing world GDP, what happens?
An inverse relationship between fixed gold standard and gold discoveries when global economies are premised on the former, then monetary stability is bound to occur. This is because the gold standard would have assumed the position of regulating the global currency values relative to the values of gold ounces or billions. This way, countries simply adjust or shift their monetary supplies relative to trends and shifts in gold supplies (Stone, 2008). Countries also get to use gold to offset the balance of payments deficits without having to tackle inflation and to print news supplies of currencies as well. Therefore, insufficient gold discoveries would trigger shockwaves and subsequent shortages of gold supplies as countries will seek to hold back on their gold reserves.
Discoveries of new goldfields tend to ignite inflation as governments gain greater leverage to print and circulate more money (notes) in the domestic markets (Stone, 2008). This causes excess liquidity in the markets and encourages the imports of expensive and non-essential items, they’re by igniting inflation due to deficits in the balance of trade. Therefore, prospects of less gold supplies due to lack of new gold discoveries are abounded to decrease money supplies at the domestic levels a move that would automatically suppress inflation. It means that the Central bank of a given country would have to stick to monetary policies that would limit its operations to within its liquidity thresholds as dictated by the value of the available gold reserves (Stone, 2008).
These controls would effectively streamline the supply of local currency because the Central Bank, as the lender of last resort, would not have much money to lend to commercial banks and it would lend the scarce amounts at increased base lending rates. Similarly, commercial banks would not have sufficient money to lend to borrowers and would have to effect upward adjustments of interest rates to meet the high costs of borrowing.
Stone, G.W. (2008). Core economics (1st ed.). New York: Worth Publishers.