A fixed exchange rate refers to an exchange rate regime where the government determines and

fixes the rate at which a currency can be traded with the currencies of a nation’s trading partners.
Madura (2012) states that the fixed exchange rate is either held constant or allowed to fluctuate
within the narrow-prescribed boundaries. The arguments for and against maintaining a fixed
spectrum of the exchange rate regime are explained below.

Increased Certainty and Stability. A fixed exchange rate system is widely known for avoidance
of wider daily oscillations that are synonymous with flexible exchange rate systems. These
fluctuations in exchange rates tend to discourage specialization in production as well as the flow
of international trade and investments. Moreover, excessive short-run fluctuations in exchange
rates under a flexible exchange rate spectrum tends to be detrimental in terms of higher frictional
unemployment, which emanates from the fact that resources will be re-allocated across the
different sectors in the economy.

However, the proponents of the flexible exchange rates have argued that the uncertainties and
instabilities associated with the fixed exchange rate regime have far reaching wider negative
repercussions and are more disruptive to the flow of trade and investments when compared to the
flexible exchange rate system. Salvatore (2013) states that the fluctuations under a flexible
exchange rate system can be hedged whereas hedging is not possible under a fixed exchange rate
regime.

Stabilizing speculation

It is argued that speculation is more likely to be destabilizing under the flexible exchange rate
system as compared to a fixed exchange rate regime. Destabilizing speculation entails the purchase
of foreign currency when the rate of exchange is rising, in the anticipation that the exchange rate
will continue on an upward trend. It also implies that speculators will sell the foreign currency
when the rate is falling, in the expectation that the rate will continue on a downward trend.
Stabilizing speculation occurs refers to the purchase of foreign currency when the rate is low in
the expectation that the rates will soon rise, or it may involve the sale of foreign currency when
the rate is high, in the expectation that the rate will soon fall.

However, proponents of the flexible exchange rates advocate that destabilizing speculation is less
likely to occur when exchange rates adjust continuously than when they are prevented from doing
so until a large discrete adjustment can no longer be avoided. Expecting a large change in exchange
rates, speculators will then sell a currency that they believe is going to be devalued and buy a
currency that they believe is going to be revalued and their expectations often become self-
fulfilling. Milton Friedman argued that speculations by all means is stabilizing because
destabilizing speculation could result in potential losses incurred by speculators.

Despite the arguments of the proponents of flexible exchange rates, the fact that destabilizing
speculation can lead to losses to speculators is a rare impediment on their self-fulfilling behaviour.
This has been evidenced by the behaviour of speculators during the Great Depression as well as
the Stock Market Crash of 1987.

Price Discipline

Fixed exchange rates instill price discipline in the economy, which is a scenario which is non-
existent under flexible exchange rates. An economy that is reeling from a high inflation rate is
likely to face persistent deficits in the current accounts as well as balance of payments. Due to the
need to avoid the persistent deficits in the economy, the economy will be compelled to check the
rate of inflation under control thereby maintaining price discipline in the economy. The automatic
adjustments of exchange rates and balance of payments adjustments lead to price indiscipline
under the flexible exchange rate system. In a nutshell, flexible exchange rates tend to exert more
inflationary pressures as compared to the fixed exchange rate system.

However, still under the fixed exchange rate system, a possible devaluation can result in
inflationary pressures being exerted in the economy. Supporters of flexible exchange rates have
however accepted the inflationary problem associated with the floating exchange rate system. In
the same vein, the flexible exchange rates are widely known to insulate an economy from external
shocks.

The weaknesses of fixed exchange rates are explained below

The fixed exchange rate system can only be maintained through a reservoir of reserves, hence it
increases the opportunity cost attached to the left idle resources. The reserves need also to be
unlimited if the rate is to be maintained, otherwise this will give rise to parallel forex market.
The fixed exchange rate system is widely criticized for rigidity in policy formulation. In order to
maintain a fixed exchange rate, internal policies should be designed in a way to achieve external
balance. The lack of flexibility in internal policy formulation might lead to some imbalances in
macroeconomic objectives, that is the fixed exchange rate system might be maintained at the high
cost or expense of high domestic inflation, unemployment and low economic growth.

However, under the fixed exchange rate regime, if the government finds out that the exchange rate
as it is; is no longer realistic and sustainable, it might need to get another fixed point either down
or upwards depending on the circumstances. If the government moves the exchange rate to a high
level (reduce the value of local currency), it is known as devaluation and a downward movement
in the exchange rate is known as revaluation.
Question 2

A fiscal policy is a set of government measures with regards to the generation revenue through
taxes and the determination of government spending. In an expansionary fiscal policy regime, the
government increases its spending and or reduce the level of taxation in an economy. The
expansionary fiscal policy is best known to be effective under the fixed exchange rate regime. This
is illustrated in the diagram below.

Price Level SRAS

Pc C SRAS1

PR R

Pe AD1

AD

YR YN Income

The initial equilibrium is at E which corresponds to the intersection of the aggregate demand curve
AD and the short run aggregate supply curve SRAS1. With the economy starting from the point of
a recession at R which also coincides with the output YR which is below the YN level of income.

The use of an expansionary fiscal policy will shift the AD curve from AD to AD1, so as to reach
equilibrium at point C and YN at the point of intersection which coincides with SRAC, AD1 and
the level of income YN. As a result of the falling domestic prices, the short run aggregate supply
will shift from SRAS to SRAS1.

The nation, however, could have reached equilibrium point E in the long run at the intersection of
the AD and SRAS curves on the LRAS curve without any expansionary fiscal policy by simply
allowing market forces to work themselves out. That is, because at point R output level YR is
below the natural output level of YN, all prices, including firms’ costs, are expected to fall, and as
prices actually fall, the SRAS curve shifts down to SRAS, so as to intersect the unchanged AD
curve at point E on the LRAS curve.

The reason is that waiting for market forces to overcome the recession might take too long. This
is especially likely to be the case if prices are not very flexible downward. Economists who believe
that prices are sticky and not very flexible downward favor the use of expansionary fiscal policy.
Those who believe that expansionary fiscal policy leads to the expectation of further price
increases and inflation prefer that a recession be corrected automatically by market forces without
any expansionary fiscal policy.
Bibliography

• Salvatore, D (2019): International Economics: Trade and Finance. USA: John Wiley and
Sons Inc 13th edition.