Exchange Rates: Float or Fixed?

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Throughout history countries have adopted both fixed and floating exchange rate systems, usually depending upon the condition of the domestic economy. The value of a currency was traditionally based on a fixed system of gold, which was known as the gold standard. However, due to the limitations incurred by the gold standard such as a restriction on growth through the lack of monetary expansion, free floating systems were adopted. Currently, most developed countries maintain a managed float system which combines aspects of a fixed rate with those of the floating rate.

Free floating exchange rate is where the market forces of supply and demand determine a currency’s value relative to another currency. There are many advantages to the use of this system, as it supports trade and achieves accurate pricing of the currency as the market forces provide price signalling. Nevertheless, the free floating system ensures no government involvement, and this reduces the possibility of market failure. With the absence of government control it is unlikely that the currency will be held at an artificially achieved price which is either over or under valued. Through letting market forces clear the exchange market events such as Black Wednesday can be avoided. Black Wednesday was when the Sterling was pegged to the Deutschmark; there was market speculation that at this exchange rate that the Sterling was being over-valued. This led onto currency traders such as George Soros to undercut the currency by short selling. This had forced the Bank of England to unpeg the currency to allow market forces to clear the market and restore the sterling to a stable value. This exemplifies the danger of fixing the currency, and how this can be easily be avoided by simply letting supply and demand determine the value. This is limited in the fact that speculation can still occur, and developing countries may want to avoid free floating as foreign investors may “bet” either way on the currency and this has national repercussions.

A fixed exchange rate system is where the value of one currency is pegged onto the value of another currency or as mentioned gold; this is done in order to maintain the value of the currency within a given band. Two mechanisms may be used to keep the currency’s value within the band, and these take the form of interest rates and foreign reserves. In a free floating system the interest rate can be varied to any degree in the interest of pursuing monetary policy, whereas in a fixed system the interest rate is only manipulate to ensure the currency’s value stays within its respective band. If the interest rate were to be kept too high, the currency would attract foreign investment leading the currency to strengthen, while the opposite can occur if the interest rate were to be lowered. This means that the government has finite ability in manipulating in the currency for domestic reasons, restricting the pursuit of monetary policies. Furthermore, in order to control the value of a currency a central bank most hold sizeable foreign reserves. The central bank must be able to freely buy and sell the currency in question, and this requires access to foreign reserves. This introduces the possibility of government failure as it is difficult to know how much a foreign currency must be held, and the possible market repercussions of having a preferred reserve currency. In the free floating system these controls are not needed, reducing the possibility of government induced failure, and the free floating system also allows greater monetary flexibility.

The free floating exchange rate system provides an automatic readjustment for an economy’s balance of payments. When a country is running a trade deficit imports are exceeding exports, prompting leakages out of the economy without introducing some kind of injection. Furthermore, as the country maintains a high demand for imports this means that there is a considerable demand for foreign currency, prompting the domestic currency to be supplied. This eventually reaches the point where the domestic currency is supplied to the extent that there is downward pressure on the currency causing it to depreciate in value. This depreciation in value means that the relative price of exports abroad decreases, making them competitive in the foreign markets. It also leads to the relative price increase of imports, as now the domestic currency is less able to purchase foreign currency. This counteracts the trade deficit as now exports will exceed imports closing the trade deficit gap. This is all achieved through the market clearing forces, rather than government intervention which may misallocate resources in an attempt to control the balance of payments. However, this does lead to a cyclical effect where the currency will have stronger and weaker periods. The main limitation in the dependency of the automatic readjustment is that it depends on the type of imports, some developing countries may have staple goods (e.g. gasoline, water, etc.) as their imports, and regardless of currency change their exports may still not be attractive, thus the adjustment does not occur or does not occur to the same extent as it would for a developed country.

Fixed exchange rate systems do promote long run stability, which can be undermined if the market is left to determine the value of the currency. It is beneficial for developing countries to maintain a peg as it helps them plan for the long run, and they need dependable trade flows. As previously mentioned the imports undertaken by developing countries may be basic necessities, so a free floating system may destabilise their ability to import the essentials. With a fixed exchange rate the developing countries can make trade agreements that will be sustainable for a length of time, and ensure some kind of economic stability. Furthermore, there is the removal of administrative costs that are persistent with the free floating system, such as futures contracts, and other types of hedging. Through running a fixed system the currency can be protected from the fluctuations of free floating currencies, which also contributes to the long term planning of developing countries, and a degree of economic stability. One key advantage of the fixed system is that it encourages firms to maintain productive and allocative efficiency so that they can compete in international trade. When a currency is pegged it is difficult to depreciate its value to make exports more competitive, thus producers are driven to allocate their resources wisely and ensure efficiency in order to cut down operational and productive costs.

When comparing the two systems it is clear that a mix of the two is suitable for many developed countries, whereas a fixed rate system has more direct benefits to developing countries who aim for stable growth. In a managed float the two fixing mechanisms can be employed in order to manipulate the value of the currency, but as the currency remains unpegged the overriding market force is that of supply and demand so it is unlikely that the currency will be over or under valued even with the use of fixed system controls. The free floating system has quite considerable benefits, as it not only reduces government intervention but also provides the automatic adjustment of the balance of payments, and monetary flexibility which has become integral in a post financial crisis economic climate.

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The Bitcoin

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If you are not living under a rock you may have already heard and read about the currency of the 21st century: Bitcoin.

For those who don’t know, Bitcoin is a virtual currency. It is basically a protocol based on a block chain made of cryptographically-signed transactions. Sounds complicated, well it is.

Up until this point in time I have refused to comment on the validity and effectiveness of Bitcoin as a virtual currency. I have left it to caveats in economic discussion with fellow students, but now there is a growing fear that Bitcoin might crash.

Overtime the intention is that there will be a limited number of Bitcoins after all the blocks are “found” and miners will only receive transaction fees rather than “newly-minted” Bitcoins. At times I feel like I am discussing currency in a video game, but this is very real.

Just today the value of Bitcoins reached over $266 (real life dollars) and then proceeded to plummet to $70 and then “stabilised” (I am using that word loosely) at approximately $105. So far it is sounding very secure and an appropriate form of investment…

Many bloggers and journalists alike are all throwing their own argument out there whether or not it is a bubble or if it can sustain a high price in the long run. I do believe in the end there may be some true value to the Bitcoin but I don’t believe that it will replace our current forms of currency.

Bitcoin boasts that it is a form of currency that is immune to inflation, bank defaults, sovereign control, or confiscation. While that is all well and good it introduces the question of its stability and its ability to withstand the short sightedness of individual consumers. This is as a result of it being a true free market in the sense that demand and supply are the only factors in consideration to its pricing.

I have friends who have already joined the hype and bought themselves Bitcoins, but I will not be joining them anytime soon. For now I will remain to be cynical and speculative, but feel free to share your opinion.

Also, just as a side note, since when has Business Insider started to use Reddit as a credible source of information?

South Africa: Sink or Swim

South Africa is currently suffering from a high rate of unemployment making it difficult for the economy to grow. Forecasted growth rates have already been downscaled as the largest economy in Africa is struggling to meet targets. The countries main contributor to GDP can be identified as consumer spending and this is why the persistent unemployment is having a considerable effect on growth forecasts.

Key Terms:

Unemployment – “Those out of work, actively seeking work at the current wage rate”

GDP/Growth – Measured by the output of an economy (gross domestic product)

Consumer Spending – Spending on retail goods, energy consumption, transportation, housing costs, and other areas where disposable income is spent.

Due to the high levels of unemployment it can be noted that there is a decline in aggregate demand within the economy. Colen Garrow states that the retail sector is weakening and there is going to be pressure overall as there is a lack of demand. It can be noted that to an extent the South African economy is contracting as there has been increased inflation as a result of a cost-push and fall in aggregate demand (shown below).

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The shift for aggregate demand from AD to AD1 is a result of the rise in unemployment, the people have less spending power and therefore there is an overall decrease in consumer demand. The shift of aggregate supply is a result of the tightening credit environment as firms struggle to meet their costs. The red rectangle represents the inflationary response in the economy as a result of the shift in aggregate supply. So as a whole the South African economy has retracted as output has significantly decreased (resulting in forecasts for future growth to decline) and there has been an inflationary response, as the price level has increased.

There is also the factor of unemployment which is 24.9% falling from the peak during Q4 of 2012 at 25.5%.This is shown simply below with a demand and supply relationship of labour in South Africa.

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Currently in the market labour is only being demanded at the point of LD but the supply is at LS. This surplus of labour is the current unemployment. With so many out of work and seeking work it is clear that economy is not working to full capacity. If a production possibility frontier for the economy was shown it would be operating within the curve. This further explains the economies inability to have substantial growth.

Consumer spending has radically decreased, making it difficult for the economy to grow and therefore attempt to combat the unemployment. This is realised by the fact that private sector demand for credit dropped from 10.09% to 8.64%. This is why the retail sector is struggling, as the unemployment and inflation has led to the decline of demand.

The unemployment in South Africa can be seen as a combination of structural and cyclical unemployment. Mining has been one of the major consumers of labour in the region, and recent closing of mines and movement by companies to other African regions for mining has meant a structural change in labour demand. The cyclical unemployment is a result of the struggling economy, as different firms reduce the amount of people they employ to meet the higher costs of production.

In the short run the economy is not likely to recover, growth is a must if the government aims to combat the high rate of unemployment. It is essential to restore consumer confidence in the economy, and also enable people to obtain credit more easily as to restore the aggregate demand of the economy.

In the long run for the economy to attempt to maintain growth, eliminating unemployment is essential to attempt to get the economy working back at a point of the PPF. However this could lead to an inflationary response in the form of a demand pull, and the government will need to begin considering how to reduce already increasing inflation as a result of increasing production costs.

Currently in the South African economy the rate of unemployment is pulling it down, in this situation there are no winners within the country. Exports may become more favourable as the inflation will weaken the South African Rand, but make investing in South Africa unlikely. To solve the unemployment in South Africa is difficult as a result of its cyclical and structural qualities; the first step would be to create more job opportunities. However, it is also essential that a greater majority of people achieve education and training whether it is academic or vocational to help improve employability prospects.

Expected growth by 2014 is forecasted at around 3.4% which is still considerable in comparison to some countries in the EU. There is still risk though investing within the country and the government must do more to encourage foreign investment and begin a round of serious structural investment such as roads to create jobs and spur on growth.

There is the potential for South Africa to climb out of the current situation, and unemployment stands at the centre of it. The country is still Africa’s biggest economy and will continue to be so if it can achieve consistency with its currency and sustained growth.