Advantages of Fixed Exchange Rate

1. If the value of currencies fluctuate significantly this can cause problems for firms engaged in Trade.

· For example if a firm is exporting to the US, a rapid appreciation in sterling would make its exports uncompetitive and therefore may go out of business
· If a firm relied on imported raw materials a devaluation would increase the costs of imports and would reduce profitability

2. The uncertainty of exchange rate fluctuations can therefore reduce the incentive for firms to invest in export capacity. Some Japanese firms have said that the Uks reluctance to join the Euro and provide stable exchange rates maker the UK a less desirable place to invest.

3. Governments who allow their exchange rate to devalue may cause inflationary pressures to occur. This is because AD increases, import prices increase and firms have less incentive to cut costs.

4. A rapid appreciation in the exchange rate will badly effect manufacturing firms who export, this may also cause a worsening of the current account.

5. Joining a fixed exchange rate may cause inflationary expectations to be lower

 

Disadvantage of Fixed Exchange Rates

1. To maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives.

· If a currency is falling below its band the govt will have to intervene. It can do this by buying sterling but this is only a short term measure.

· The most effective way to increase the value of a currency is to raise interest rates. This will increase hot money flows and also reduce inflationary pressures.

· However higher interest rates will cause lower AD and economic growth, if the economy is growing slowly this may cause a recession and rising unemployment

2. It is difficult to respond to temporary shocks. For example an oil importer may face a balance of payments deficit if oil price increases, but in a fixed exchange rate there is little chance to devalue