Assess the view that floating exchange rates are always better than fixed exchange rates
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Course
The national and international economy
Institution
AQA
A Level AQA Economics essay - the International Economy - Exchange Rates
24/25 marked essay
Title - Assess the view that floating exchange rates are always better than fixed exchange rates.
Essay complete with real world examples, statistics, and diagrams, such as equilibrium adjustment wi...
1. Assess the view that floating exchange rates are always better than fixed exchange rates.
[25]
Countries adopt different exchange rate (ER) systems in order to best suit their needs, maintain
stability, and promote economic growth. An ER measures how much of another currency a particular
currency can buy and is the external price of a currency quoted by another currency. There is a
broad spectrum of ER systems, but notably free-floating, fixed, and managed ER systems are the
most popular ones around the world. Floating ERs are when the market value of the currency is
determined by supply and demand, whereas fixed ERs are fixed at a certain level by the country’s
central bank and maintained by the bank’s intervention in the foreign exchange market. Through an
analysis and evaluation of floating ERs and their effects on domestic and international scales, they
obviously have their strengths, such as flexibility, independence, stability, resource allocation, and
domestic policy freedom, but they are not always better than fixed ERs, which are beneficial
especially to developing countries or economies going through a recession. Therefore, floating ERs
are not always better than fixed ERs, but can be seen as usually superior, especially in the global
North.
Floating ER systems are determined by market forces and
when comparing them to fixed exchange rates, they can be
seen as beneficial, as seen through the flexibility,
independence, increased stability, and enhanced
competitiveness, evident through balance of payments
(BoP) equilibrium, improved resource allocation, more
freedom to implement domestic policies and monetary
policies, and inflation being easier to control. Floating ERs
can be seen as always better than fixed ERs through the
BoP equilibrium as, through the rate being determined by
market forces, the rate should automatically move up or
down to adjust to the BoP. If there is an overvalued ER
causing decreased competitiveness and a BoP deficit,
market forces should push down the ER towards the
equilibrium price, thus alleviating the BoP deficit also. This
can be seen through this diagram which shows an
adjustment of the ER. The increased demand for the
exchange rate to pay for imports causes a shift to the right
in the supply curve from S1 to S2, thus meaning that there
is a payment deficit in the account of the ER stays at £1.30. there is then excess supply of sterling on
the foreign exchange market, as seen through the distance of A-B, and so the market forces come in
and adjust the equilibrium, found at point C, causing the pound’s ER to fall, resulting in an increase in
price competitiveness of UK exports. This process occurs without the need for government policies
and the buying or selling of currencies to adjust the exchange rates and is therefore an easier, more
flexible system. This would not occur in a fixed ER system, as if the currency was overvalued, a BoP
deficit would occur, as well as deflation and a loss of output, and there may be time lags that occur
from when the ER is overvalued to when it is amended, contrasting the floating ER which would be
adjusted immediately. Through this, an economist can observe that a free-floating ER system is
significantly more efficient at amending BoP deficits and surpluses through its flexibility, thus
preventing further damage to the economy such as deflation, loss of international competitiveness,
increased unemployment, and more. However, countries may want to strategically set their
currency at a certain level, which floating ERs would not allow, implying that fixed ERs may be more
stable and may suit countries that are significant international exporters and importers, as seen
through China’s ER system, as floating ERs can fluctuate, damaging economic growth and
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