Tue | Sep 26, 2017

Fixed vs floating exchange rate regimes

Published:Wednesday | February 11, 2015 | 2:00 AM

THE JAMAICAN economy is now primed for growth, and there have been some discrepancies as to whether or not a floating exchange-rate regime has been the most suitable approach to currency management, or would it be better if the country adopts a less flexible-exchange rate system.

Both have their advantages and disadvantages, and the ultimate choice usually depends on the country's ability to effectively implement either of the two.

Historically, the choice of exchange-rate regime (fixed or floating) was designed to suit the goals of the country's macroeconomic policy, in line with the economic objectives the country wants to achieve.

Jamaica has experienced a version of both types of exchange-rate mechanisms in the past, and there are lessons to be learnt, not just from Jamaica's own experience, but from the experiences of other countries that have experimented with a version of either type of regime as well.

 

fixed exchange-rate advantages

 

There are several advantages to adopting some sort of fixed exchange-rate regime.

1. It provides more certainty about import and export prices. Merchants have a clear idea of the price they will pay for foreign currency, ahead of time, which makes planning for foreign purchases easier.

2. Prices are relatively stable, here price changes are relatively low and does not increase as rapidly as in a floating exchange-rate system. The inflation rate was less than 10 per cent during the late 1980s when Jamaica predominantly maintained a relatively stable exchange rate against the United States. In the early 90s, the financial sector was liberalised and the exchange rate began to depreciate more rapidly, and prices also increased more rapidly. The inflation rate in 1992 was approximately 80 per cent.

3. There is more economic stability and less uncertainty when the exchange rate is predetermined.

These advantages, however, are sometimes questionable if a country artificially keeps its currency at an unrealistic fixed value. A country might encounter more problems if:

1. It fixes its exchange rate below its true value. Argentina previously ran into a crisis due to a situation like this. It artificially fixed the value of its currency for quite some time, but ran into problems after realising the currency was overvalued. Subsequently, its debt increased and it had to default in some cases. Argentina is a classic example of fixed exchange rate (currency board) gone wrong.

The situation is described by many as a bad outcome of a high-risk solution to a weak currency problem. Argentina's situation might be similar to the situation in Jamaica, which the country can learn from.

2. The central bank cannot implement the proper exchange rate-control mechanisms to help keep the currency stable. To keep the currency fixed at a specific value, the central bank must implement exchange-rate controls.

For example, in Barbados, each person is allowed to make purchases of only US$500 per day.

If Jamaica were to adopt some sort of fixed exchange regime, the central bank would have to decide the dollar amount purchases the country can afford each person per day.

Some believe Barbados should add some amount of flexibility in the determination of its exchange-rate value in the near future.

3. If the central bank cannot muscle up enough reserves to intervene in the market, when the supply of foreign currency is low, by fixing the exchange rate, demand and supply are no longer the true determinants of the exchange rate.

If the exchange rate is too low, demand for the currency might be too high. In this case, the central bank might not have enough reserves to satisfy demand on a consistent basis.

Jamaica operates a floating exchange-rate regime. The country has to borrow from the IMF to support the reserves on an annual basis.

With a floating exchange rate regime, the Jamaican currency has been depreciating, putting a lot of pressure on manufacturers, as the price of imported inputs for their production processes have been increasing, which has limited how much they can produce and, ultimately, their profits.

Over the last year, both exports and imports have been falling, imports more than exports, which have improved the country's trade balance. All this remains insignificant as there is no great increase in the country's total output. Jamaica's problem is beyond fixed or floating exchange rate. It is about production and productivity.

Even if the exchange rate is fixed, the situation in the country will not improve unless there is positive long-run productivity shock, employing domestic indigenous inputs.

- Dr Andre Haughton

is a lecturer in the Department of Economics at the Mona campus

of the University of the

West Indies. Follow

him on Twitter @DrAndreHaughton; or email editorial@gleanerjm.com.