1. What are the advantages and disadvantages of both a fixed exchange rate regime and a flexible
exchange rate regime?
There are two ways the price of a currency can be determined against another. A fixed, or pegged,
rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set
price will be determined against a major world currency (usually the U.S. dollar, but also other
major currencies such as the euro, the yen, or a basket of currencies). In order to maintain the
local exchange rate, the central bank buys and sells its own currency on the foreign exchange
market in return for the currency to which it is pegged.
If, for example, it is determined that the value of a single unit of local currency is equal to USD
3.00, the central bank will have to ensure that it can supply the market with those dollars. In order
to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved
amount of foreign currency held by the central bank which it can use to release (or absorb) extra
funds into (or out of) the market. This ensures an appropriate money supply, appropriate
fluctuations in the market (inflation/deflation), and ultimately, the exchange rate. The central bank
can also adjust the official exchange rate when necessary.
Floating
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply
and demand. A floating rate is often termed "self-correcting", as any differences in supply and
demand will automatically be corrected in the market. Take a look at this simplified model: if
demand for a currency is low, its value will decrease, thus making imported goods more expensive
and thus stimulating demand for local goods and services. This in turn will generate more jobs, and
hence an auto-correction would occur in the market. A floating exchange rate is constantly
changing.
In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can
also influence changes in the exchange rate. Sometimes, when a local currency does
reflect its true value against its pegged currency, a "black market" which is more
reflective of actual supply and demand may develop. A central bank will often then be
forced to revalue or devalue the official rate so that the rate is in line with the unofficial
one, thereby halting the activity of the black market.
In a floating regime, the central bank may also intervene when it is necessary to ensure
stability and to avoid inflation; however, it is less often that the central bank of a floating
regime will interfere.
Answer
Fixed vs. Flexible
Fixed advantages
A fixed exchange rate should reduce uncertainties for all economic agents in the country.
As businesses have the perfect knowledge that the price is fixed and therefore not going
to change they can plan ahead in their productions. Inflation may have a harmful effect
on the demand for exports and imports. To ensure that inflation is kept as low as
possible the government is forced to take measurements, to keep businesses competitive
in foreign markets. In theory a fixed exchange rate should also reduce speculations in
foreign exchange markets. In reality this is not always the case as countries want to
make speculative gains.
Fixed Disadvantages
The government is keeping the exchange rate fixed by manipulating the interest rates. If
the exchange is in danger of falling the government needs to increase interest rates to
increase demand for the currency. As this would have a deflationary effect on the
economy the demand might decrease and unemployment might increase. A government
has to maintain high levels of foreign reserves to keep the exchange rate fixed as well as
to instill confidence on the foreign exchange markets. This makes clear that a country is
able to defend its currency by the buying and selling of foreign currencies. Fixing the
exchange rate is not easy as there are many variables which are changing over time if
the exchange rate is set wrong it might be hard for export companies to be competitive
in foreign countries. International disagreement might be created when a country sets its

2. exchange rate on a too low level. This would make a countries export more competitive
which might lead to a disagreement between countries as they might see it as an unfair
trade advantage.
Flexible Advantages
As the exchange rate does not have to be kept at a certain level anymore interest rates
are free to be employed as domestic management policies(Appleyard 703). The floating
exchange rate is adjusting itself to keep the current account balanced, in theory. As the
reserves are not used to control the value of the currency it is not necessary to keep high
levels of reserves (like gold) of foreign countries.
Flexible Disadvantages
Floating exchange rates tend to create uncertainty on the international markets. As
businesses try to plan for the future it is not easy for the businesses to handle a floating
exchange rate which might vary. Therefore investment is more difficult to assess and
there is no doubt that excursive exchange rates will reduce the level of international
investment as it is difficult to assess the exact level of return and risk. Floating exchange
rates are affected by more factors than only demand and supply, such as government
intervention. Therefore they might not necessarily adjust themselves in order to
eliminate current account deficits. The floating exchange rate might worsen existing
levels of inflation. If a country has higher inflation rate than others this will make the
export of the country less competitive and its imports more expensive. Then the
exchange rate will fall which could lead to even higher import prices of goods and
because of cost-push inflation which might drive the overall inflation rate even more.
While flexible exchange rates can ensure that the country achieves external balance,
they do not ensure internal balance. In several situations the exchange rate change that
reestablishes external balance can make an internal imbalance worse. If a country has
rising inflation and a tendency toward external deficit, the depreciation of the currency
can intensify the inflation pressures in the country. If a country has excessive
unemployment and a tendency toward surplus, the appreciation of the currency can
make the unemployment problem worse. To achieve internal balance, the country's
government may need to implement domestic policy changes.
Q1 a)Explain why a stronger dollar could enlarge the U.S. balance of trade deficit. Explain
why a weaker dollar could affect the U.S. balance of trade deficit.
a. The dollar is presently weak and is expected to strengthen over time. These expectations
affect the tendency of U.S investors to invest in foreign securities because the value of U.S
dollar decrease will lead to the U.S company get less profit and earn less money.
Consequently, U.S companies will pay fewer dividends for investors who invest in these
companies. So, investors will tend to invest in foreign securities where they can get higher
dividend. On the other hand, a weak currency can reduce unemployment but maybe it can
lead to high inflation, and simultaneously it may reduce U.S imports and boost U.S exports or
buy more goods than it sells abroad (imports exceed exports). Another thing, in the long run,
trade deficits may be expected to contribute to a weaker dollar, as the economy adjusts to
create the surpluses needed to repay foreign investors. However, in the short run, the
relationship between the trade deficit and the dollar is weak, and the value of the dollar is
determined largely by investor preferences for U.S. dollar assets.
On the other hand, when U.S dollar is strong again, it will make the value of U.S dollar
increase. A strong dollar will make exports more expensive to foreign consumers and also
make imports cheaper. Hence, it encourages imports and reduces exports, and maybe
increasing the balance of trade deficit. However, when the U.S dollar has stronger than other
dollars such Singapore dollar, Yen, Euro or Canadian dollar, the value of the U.S dollar is a
dependant variable by which it is determined by supply and demand. The consumptions will

3. reduce and exports are the same, and against imports will increase. So it will make to
enlarge the U.S balance of trade deficit. For instant, in 2006, U.S exports to China were
about $55 billion, but imports from China were about $255 billion, which result in a balance of
trade deficit of $200 billion with China (Jeff Madura, 2008, p.26).
b. A current account deficit in the U.S...