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QUESTION 7 - Fixed and Floating exchange rates
Explain the difference between fixed and floating exchange rate regimes and how they work
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Cf
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10)

Introduction and conceptualizations:
Fixed & Floating Exchange Rates are part of the ​Foreign Exchange Market (FOREX)​, where the foreign currency
is government by supply and demand, on the basis of the ​exchange rate​
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- residents of a country ​supply their country’s currency on the FOREX market by purchasing imported
goods and services and foreign financial assets
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- the ​exchange rate​: the price that a person must pay in his/her own country’s currency to purchase
one unit of a foreign currency
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- the ​flexible or ​floating exchange-rate regime occurs when the government allows the market forces to
determine the exchange rate
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Explaining the mechanisms:
In a flexible exchange rate regime:
- the ​demand function of a currency is ​downward sloping, as the price of a currency goes down, the
opposite country demand more of it (fore purchasing, investing, or hedging strategies)
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​(FDI ?)
- A country is more likely to purchase the goods of a another country where the exchange rates
depreciates (the exchange rate goes down, because the same goods become “cheaper”), leading to a
variety of circumstances:
- the ​tastes in a country's goods (where the currency is depreciating) are developing impacting
the economy but also the reputation
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- the ​income of the country where the currency appreciates ​enjoys a dramatic increase in
incomes​ leading to a greater demand for the goods of the opposite country
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This includes a number of responsibilities:
- The government has to quickly satisfy the new demand for currencies otherwise a ​black
market could surge, in which the rate would be higher than the official one, diverting away
the money from the legal to the illegal system and exacerbating a shortage in the open
market
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There is a risk that the government exhaust its
holding of foreign currencies, then becomes unable to maintain the exchange rate, and will
be forced to admit the exchange rate to decline to some level or switch to the floating
regime
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Stability encourages investments:​ if uncertainty
around the exchange rate occurs, some invests or
financial institutions might withdraw their
investment and diversity in other countries
(cumulated disadvantage)
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Brexit
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Conflict with other macroeconomic objectives:
the most effective way for countries to solve a
pressured depreciating currency is the raise of
interest rates (reducing inflationary pressures)> BUT
this leads to lower aggregate demand and lower the
economic growth
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Less flexibility: In fixed exchange rate, it is difficult to
respond to temporary shocks
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if a country is a net
importer of an essential good which price increases,
it will suffer in its balance of payments
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(cf
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No impact on the domestic policies:​ a government
can adopt an independent monetary policy
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Because of the self-adjusting mechanism of BoP
equilibrium, the government can put more effort
into tackling internal problems like inflation,
unemployment, etc
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There is therefore a large proportion of
financial wealth which is spent on hedging strategies
or speculative activities (collateral securities and
packaged assets) instead of tangible investments for
the population
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