Economics of Globalisation Format: Essay Length: 2500 words (references are not included) References: APA referencing style From 2010 until early 2013, the Australian dollar appreciated against many...

Abstract
Since years, the debate on the superiority of flexible exchange rate system over fixed
exchange rate is going on. In this paper we will discuss several merits and demerits of the
same. The Australian dollar has appreciated strongly over the last few years, leading to
increased concerns over the impacts of the high exchange rate on trade-exposed sectors of the
economy. This paper examines the mainreasons behind this and the implications of various
policy options that might be adoptedto lower the exchange rate. Finally, this paper describes the
different methods adopted by the Central bank or a government may use to influence the value
of a currency.
Exchange rate is the rate at which one currency can be converted into another currency.
In other words, the rate of exchange denotes the price of a currency in terms of another.
Exchange rates are generally determined by the theory of demand and supply. This
theory states that, like the price of any other commodity, the price of foreign exchange is also
determined by the forces of demand and supply. That rate of exchange which brings about
equilibrium in the balance of payments is known as the equilibrium rate of exchange. The
following diagram shows that the equilibrium exchange rate is determined at the intersection of
the demand and supply curves. It is seen that the demand and the supply curves for currency
intersects a E, where the equilibrium exchange rate is Or0. If the rate falls to Or1, then there will
be an excess demand amounting to AB. Therefore price of currency will rise and the equilibrium
rate of exchange Or0 will be achieved. Similarly, if the exchange rate rises to Or2, then there will
be an excess supply of MN. Hence, equilibrium exchange rate will fall to Or0.
If there is disequilibrium in the balance of payments of any country, then there are two
methods of adjustments –
i) Fixed Exchange rate system
ii) Flexible exchange rate system
In the fixed exchange rate system, the rate of exchange remains fixed and the
disequilibrium is corrected through change in domestic price and income levels. On the other
hand, in the flexible exchange rate system the rate of exchange changes when there is
disequilibrium. Whether a country should adopt a fixed or flexible exchange rate system, is
determined by the following four factors: (a) uncertainty (b) speculation (c) inflation and (d)
unemployment. Both the exchange rate systems have their own advantages and
disadvantages. If flexible exchange rate system is susceptible to inflation, fixed exchange rate
system is susceptible to unemployment. Thus, there is no neat answer to the question regarding
whether a country should adopt the fixed exchange rate system or the flexible exchange rate
system.
Part-a
Now, we will discuss the advantages and disadvantages associated with flexible /
floating exchange rate systems. Let us start with the advantages.
Advantages of Flexible Exchange Rates
The main advantages of a floating exchange rate system are as follows:
a) Independent Monetary Policy: Under flexible exchange rate system, the
exchange rate a country adjusts automatically when the exchange rate market is
in disequilibrium. Hence the country can adopt an independent monetary policy
to stimulate the economic growth of the country. Thus the monetary policy of a
country with flexible exchange rate system is not limited or affected by the
economic conditions of other countries.
b) Shock Absorber: Sometimes countries receive external shocks due to
disturbances in foreign currencies. A country with flexible exchange rate system
is less prone to these shocks because, a fluctuating exchange rate system has
the potential to absorb these shocks by adjusting the exchange rates
automatically. Thus, it acts as a shock absorber and saves the internal economy
from the disturbing effects from abroad.
c) Promotes Economic Development: The floating exchange rate system acts as
a promoter of economic development.It also helps the economy to achieve a full
employment situation. The exchange rates changes automatically with different
monetary policies adopted for achieving certain domestic objectives.
d) Solutions to Balance of Payment Problems:One of the main advantages of
the flexible exchange rate system is that this exchange rate system automatically
corrects any balance of payments (bop) disequilibrium, if present. Suppose that
initially there is deficit in the balance of payments. This will lower the value of the
domestic currency.This will encourage exports and simultaneously discourage
imports. Thus the balance of payment of the domestic country will improve and
equilibrium will be restored.
e) Promotes International Trade: Since exchange rates under this system adjust
automatically through the interaction of market forces, there is no restriction on
international trade. Thus goods and services can move freely between countries.
f) Increase in International Liquidity: The system of flexible exchange rates
removes the requirement of keeping foreign exchange reserves, if the individual
governments do not employ stabilization funds to influence the rate. This solves
the problem of international liquidity.
g) Market Forces at Work:Under the floating exchange rate system, the
equilibrium exchange rates are automatically determined by the interaction of
demand and supply. This clears the market automatically and the possibility of
scarcity or surplus of any currency is also done away with.
Disadvantages of Flexible Exchange Rates
The major drawbacks of the flexible exchange ratesystem are as follows:
a) Low Elasticities:If the elasticities in the international markets are too low , then
exchange rate variations cannot...