Question

Critically comment on the following statements as they refer to middle-income developing countries (1 page )

"Cyclical and chronic overvaluations can be explained in the context of a floating or fully flexible exchange rate system, but not in the context of a fixed exchange rate regime."

Answer 1

Cyclic and chronic overvaluation can be not be explained in the context of of floating or fully flexible exchange rate system. The reason is that exchange rate can't remain at high for long time under flexible interest rates. If it is high speculators will rightly speculate that it will fall soon. So they will move out of this currency and invest in foriegn countries to make profits when exchange rate would fall. They will then exchange same unit of foriegn currency for greater no. Of units of domestic currency.

But chronic overvaluations are more likely under fixed exchange rate system. The reason is quite often developing countries keep their exchange rate high so that they can import foreign machinery at low prices. This leads to artificial overvaluation. As exchange rate here is not determined by demand and supply, it will continue to remain artificially high. With the result that import of machinery is less costly but at the same time country looses because it's exports are costly. Though it might be said that due to wrong expectations cyclic overvaluation can result under flexible exchange rate system.