The relationship between the exchange rate regime and macroeconomic performance is ambiguous. The two major types of exchange rates include fixed and floating exchange rates (Geringer, Minor, & McNett, 2012). Research has revealed that the type of exchange rate adopted by a country and the rate of inflation are related entities. A fixed exchange rate is associated with low inflation. However, it is associated with sluggish productivity growth.
A low rate of inflation comes from the positive effect of enacting strong fiscal policies that develop confidence in a country’s currency. On the other hand, low inflation emanates from fixed exchange rates due to the maintenance of a foreign exchange rate peg (Geringer et al., 2012). The relationship between an exchange rate regime and growth is determined by the system applied an exchange rate set at an appropriate level boosts investment because of increased confidence in monetary policies. In contrast, exchange rates pegged at wrong levels suppress growth due to low levels of investment and misallocation of resources (Geringer et al., 2012).
Countries that have pegged exchange rates experience high growth rates due to the increase in investments. Pegged exchange rates spur growth and lower inflation for two main reasons. First, they increase the financial costs of fiscal policies that affect economic growth. Second, they bolster confidence in investors who respond by holding the local currency, thus lowering inflation. Floating and fixed exchange rate systems have different effects on inflation and economic expansion. Pegged rates spur economic growth because of high rates of investment. They are also associated with slow productivity growth. Studies have revealed that output growth is lower in economies that operate under pegged exchange rates. Flexible regimes are necessary for economies that experience slow growth.
Why is credibility important to maintain a fixed exchange rate?
In many countries, policymakers face several challenges when using exchange rates as instruments for economic change and growth. Credibility is important in maintaining a fixed exchange rate because of the uncertainty associated with monetary and fiscal policies. In addition, it increases investments by creating confidence in investors (Madura, 2014). Credibility initiates commitment to non-inflationary monetary policies that are essential for economic growth.
A fixed exchange rate enhances commitment to monetary policies and prevents unrestricted policies that are perilous to financial stability. Proponents of fixed exchange rates argue that pegged systems suppress the emergence of variability and uncertainties associated with floating exchange rates (Madura, 2014). These uncertainties initiate direct and indirect costs that suppress investment and growth. Credibility eliminates the problem of dealing with the negative effects of variable and unpredictable exchange rates. Floating exchange systems initiate challenges that affect the valuation of currencies (Madura, 2014).
Overvaluation on the undervaluation of currencies has adverse effects on economies due to costs involved. One of the disadvantages of fixed rates is their propensity to break down. Governments incur costs of such breakdowns when they deal with currency misalignments and economic distortions. Credibility in maintaining fixed exchange rates aid in the avoidance of these challenges. Investments are high in economies that implement policies that prevent currency misalignments, currency devaluations, and baking systems crises (Madura, 2014).
Credible monetary policies cushion investors against currency devaluation that has adverse effects on international trade and investment. In addition, credible policies are needed by countries that adopt disinflation programs in an effort to lower inflation and thus foster economic growth. Finally, credibility enhances the stability of currencies and, as such, promotes international trade (Madura, 2014).
Geringer, M., Minor, M., & McNett, J. (2012). International Business. New York: McGraw-Hill Education.
Madura, J. (2014). International Financial Management. New York: Cengage Learning.