Harvad Management Company Case Study
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The three approaches used are:
1) Floating Regime
2) Fixed
3) Pegged against the U.S dollar
Managed float (dirty float):
Advantages:
Provide a nominal anchor for monetary policy
Reduce transactions costs and exchange rate risk intl trade & investment
Disadvantages:
Loss of monetary policy autonomy
Loss of exchange rate as a shock absorber
=>Consequences for output and employment
Loss of lender of last resort (?)
Danger of speculative attacks and crashes
Loss of seignior age revenue (in the case of dollarization)
Pegged Currency:
Advantages:
A pegged currency can be very useful in combating inflation in an environment where the public has lost confidence in the nations economic policies, and prices keep rising uncontrollably as a result.
To defend the profits of exporters in a nation against normal currency fluctuations which make predictions difficult.
A peg may be implemented to facilitate convergence between the financial systems of two nations where increased cooperation, or even ultimate merger is desired.
By pegging the currency, the central bank of the nation is declaring its intention to limit its expansion of the money supply by adhering to policies of the other, more credible central bank. It gives up its independence in setting policy rates and following its own currency policies in response to domestic needs, but in return gains the ability to rapidly suppress inflation expectations that are otherwise uncontrollable. Usually, the central bank of a fixed currency will change its interest rate policy on the same day, and in the same percentage value of the controlling central bank. If they had not done so, arbitrageurs in the market would quickly exploit the situation, quickly making the fixed exchange regime untenable.
Disadvantages:
A currency peg adopted at a time when the nation possessed ample forex reserves is unlikely to function well when the current account surplus evaporates and all that defends the rate is the intervention promise of the central bank. Market participants are unlikely to regard such a promise seriously, and this lack of credibility has the potential to create currency crises, once speculators force authorities to make good on their promises.
A fixed exchange system doesnt react to changes, and unless the authorities eventually readjust the exchange rate through a process known as devaluation.
floating regime
Advantages:
1. Automatic balance of payments adjustment:
Any balance of payments disequilibrium will tend to be rectified by a change in the exchange rate. For example, if a country has a balance of payments deficit then the currency should depreciate. This is because imports will be greater than exports meaning the supply of sterling on the foreign exchanges will be increasing as importers sell pounds to pay for the imports. This will drive the value of the pound down. The effect of the depreciation should be to make your exports cheaper and imports more expensive, thus increasing demand for your goods abroad and reducing demand for foreign goods in your own country, therefore dealing with the balance of payments problem. Conversely, a balance of payments surplus should be eliminated by an appreciation of the currency.
2. Freeing internal policy:
With a floating exchange rate, balance of payments disequilibrium should be rectified by a change in the external price of the currency. However, with a fixed rate, curing a deficit could involve a general deflationary policy resulting in unpleasant consequences for the whole economy such as unemployment. The floating rate allows governments freedom to pursue their own internal policy objectives such as growth and full employment without external constraints.
3. Absence of crises:
Fixed rates are often characterized by crises as pressure mounts on a currency to devalue or revalue. The fact that, with a floating rate, such changes are automatic