Question

Low-income nations have a dilemma as to whether to fix or float the currency exchange rates. There are many factors that affect their decisions and how effectively they can manage a financial system. Discuss a few of these factors that contribute to the success of a policy.

Answer 1

Floating exchange rate: The currency price of a nation is set by the forex market based on supply and demand relative to other currencies. Floating exchange rates became more popular after the failure of the gold standard and the Bretton Woods agreement.

Fixed exchange rate: A fixed exchange is another currency model, and this is where a currency is pegged or held at the same value relative to another currency. This is normally applied by a government or Central bank to keep a currency's value within a narrow band. As the rate is set against another major world currency (such as the U.S. dollar, euro, or yen). To maintain its exchange rate, the government will buy and sell its own currency against the currency to which it is pegged. Some countries that choose to peg their currencies to the U.S. dollar include China and Saudi Arabia.

There are many factors that affect their decisions on choosing fixed of floating exchange rate. Few of them are;

Terms of International trade

- Increasing terms of trade shows' greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency and an increase in the currency's value. The terms of trade are related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved.

- Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched, analyzed and governmentally manipulated economic measures.

Demand and supply of currency:

- Since floating rate calculated based on supply and demand. The demand for the currency is high, the value will increase. If demand is low, this will drive that currency price lower. Short-term moves in a floating exchange rate currency reflect speculation, rumors, disasters, and everyday supply and demand for the currency. If supply outstrips demand that currency will fall, and if demand outstrips supply that currency will rise.

- Developing economies often use a fixed-rate system to limit speculation and provide a stable system. A stable system allows importers, exporters, and investors to plan without worrying about currency moves.

Public Debt of the country:

Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. A large debt encourages inflation, if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.

Current account Deficit.
The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest, and dividends. The country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.