Fixed Exchange Rate-When a country's currency is fixed to another currency or to another measure of value such as gold.
Advantage:
-Reduces uncertainty. Businesses planning on trading with a country with a fixed exchange rate will know their predicted costs and prices and be sure that they are not going to change.
-Because inflation has such a detrimental effect on an economy with a fixed exchange rates, as demand for exports and imports would change drastically with a change in inflation, government policies must be sensible dealing with inflation.
Disadvantages
-The main way to keep the exchanger rate fixed is through the manipulation of the interest rate. For example, if the exchange rate is in danger of falling, the government will have to raise the interest rate in order to increase demand for the currency, but this increases unemployment.
-Has to maintain high levels of foreign reserves to be able to defend its currency in the buying and selling of foreign currency.
-Finding the exact right value that the exchanger rate should be set at is challenging. If the rate is set at the wrong level, then this could mean that the country is not competitive in foreign markets.
-A country that fixes its exchanger rate at an artificially low level may create conflict with other countries because this will make their exports more competitive on the world market and may seem like an unfair trade advantage to other countries. This can be seen in Figure 1, as setting the fixed exchange rate too low causes a shortage in the supply of their currency because foreign countries are now demanding their currency for the low price of their exports.
Floating Exchange Rate-A country's currency is allowed to fluctuate according to the foreign exchange market.
Advantages:
-Because the exchange rate does not have to be kept at a certain level, interest rates can be used as monetary tools and for demand management policies, such as controlling inflation.-It is unnecessary for a country with a floating exchange rate to keep high levels of reserves of foreign currency and gold because the reserves do not control the value of the currency.
Disadvantages:
-Can create uncertainty on international markets, as it is hard for businesses to predict their costs and revenus. Can reduce investment as well because it is difficult to assess the level fo return and risk.
-Floating exchange rates, contrary to theory, are affected by more than supply and demand such as government intervention, world events and speculation, so sometimes the exchange rates do not naturally adjust to eliminate current account deficits.
Advantages to a Single Currency System
-Reduces the level of transaction costs. Ex. Countries in the Eurozone do not have to keep changing currencies in order to trade so they do not have to pay commission on currency exchage.
- Reduction in risk and increase in business confidence for members of the union. Ex. Business don't have to worry about exchange rate fluctuations and in turn changes in their relative costs and prices.
-Easier to make price comparisons between member countries.
-Greater FDI attraction between union members as there will be reduced transaction costs, reduced uncertainty and the single currency market will be larger.
Disadvantages
-Individual countries lose the ability to set their own interest rate levels and so no longer have the ability to adopt an independent monetary policy.
-Member countries don't have the ability to ease balance of payment problems as they cannot depreciate or devalue the currency.
-There are often a lot of transaction costs involved with changing from a national currency to a single currency as the government has to change the currency but domestic firms as well have to reprogram computers and produce new price lists. This is a one time cost though.
Advantage:
-Reduces uncertainty. Businesses planning on trading with a country with a fixed exchange rate will know their predicted costs and prices and be sure that they are not going to change.
-Because inflation has such a detrimental effect on an economy with a fixed exchange rates, as demand for exports and imports would change drastically with a change in inflation, government policies must be sensible dealing with inflation.
Disadvantages
-The main way to keep the exchanger rate fixed is through the manipulation of the interest rate. For example, if the exchange rate is in danger of falling, the government will have to raise the interest rate in order to increase demand for the currency, but this increases unemployment.
-Has to maintain high levels of foreign reserves to be able to defend its currency in the buying and selling of foreign currency.
-Finding the exact right value that the exchanger rate should be set at is challenging. If the rate is set at the wrong level, then this could mean that the country is not competitive in foreign markets.
-A country that fixes its exchanger rate at an artificially low level may create conflict with other countries because this will make their exports more competitive on the world market and may seem like an unfair trade advantage to other countries. This can be seen in Figure 1, as setting the fixed exchange rate too low causes a shortage in the supply of their currency because foreign countries are now demanding their currency for the low price of their exports.
Floating Exchange Rate-A country's currency is allowed to fluctuate according to the foreign exchange market.
Advantages:
-Because the exchange rate does not have to be kept at a certain level, interest rates can be used as monetary tools and for demand management policies, such as controlling inflation.-It is unnecessary for a country with a floating exchange rate to keep high levels of reserves of foreign currency and gold because the reserves do not control the value of the currency.
Disadvantages:
-Can create uncertainty on international markets, as it is hard for businesses to predict their costs and revenus. Can reduce investment as well because it is difficult to assess the level fo return and risk.
-Floating exchange rates, contrary to theory, are affected by more than supply and demand such as government intervention, world events and speculation, so sometimes the exchange rates do not naturally adjust to eliminate current account deficits.
Advantages to a Single Currency System
-Reduces the level of transaction costs. Ex. Countries in the Eurozone do not have to keep changing currencies in order to trade so they do not have to pay commission on currency exchage.
- Reduction in risk and increase in business confidence for members of the union. Ex. Business don't have to worry about exchange rate fluctuations and in turn changes in their relative costs and prices.
-Easier to make price comparisons between member countries.
-Greater FDI attraction between union members as there will be reduced transaction costs, reduced uncertainty and the single currency market will be larger.
Disadvantages
-Individual countries lose the ability to set their own interest rate levels and so no longer have the ability to adopt an independent monetary policy.
-Member countries don't have the ability to ease balance of payment problems as they cannot depreciate or devalue the currency.
-There are often a lot of transaction costs involved with changing from a national currency to a single currency as the government has to change the currency but domestic firms as well have to reprogram computers and produce new price lists. This is a one time cost though.