Inflation Rates

.. le exchange rates could accommodate differential inflation rates(Corden 179). Since then, all major industrial countries have followed the U.S. and allowed their currencies to float also. So each country has the freedom to find their own values in relation to other currencies to set their own exchange rates, but the central banks still have the authority to intervene occasionally to prevent large short-term fluctuations in the exchange rates.

There are, at least, some advantages to freely floating rates. They can act as shock absorbers. The biggest advantage of floating exchange rates is that they give each country control over its domestic affairs. Some economists favor floating rates for many of the same reasons that they favor a free market system; these people believe that currency prices should be determined by supply and demand, and not just by government regulation. On the other hand, there are bankers and international traders that tend to prefer fixed exchange rates because they are much more reliable for doing business. If there are floating exchange rates there may be large fluctuations in a very short period of time that could possibly result in a recession or inflation in their country.

Exchange rate changes that deviate from their equilibrium values lead to adjustment problems and real effects on the economy. Econometric studies of impact of foreign exchange rate variation on foreign direct investment typically focus on the short-term variability of exchange rates(Hasnat 235). One can see the effects of the exchange rate on other aspects of the economy if you examine it closely. One major impact the exchange rates have on the economy deals with imports and exports. Exchange rates tell how much one currency is worth in terms of another, so for an example to compare the effect on imports and exports to domestically produced goods, we can examine a situation with the Japanese yen and the U.S. dollar.

The higher the cost of a yen in terms of dollars also means the lower the cost of dollars per yen. The result is the Japanese would much rather buy American goods because they can get more in terms of an American dollar. Also, the American demand for Japanese goods will be lower since Americans can get more value out of their own currency when purchasing American goods. Demand and supply with international trade is also affected greatly by the exchange rates. Americans who want to buy, for example, Japanese goods, which would be Japanese exports and American imports, demand yen.

The lower the price of yen, and therefore the lower the exchange rate between the yen and dollars will make it cheaper to purchase Japanese goods with dollars. So there will be a higher demand for yen in this case because Americans will exchange their dollars for yen, and then buy the Japanese goods. As for the supply of yen, the Japanese who buy U.S. goods, which would be U.S. exports and Japanese imports, would supply the yen with these purchases. To help determine this quantity supplied, Japanese would supply more yen if the price of the yen was high or the value of the dollar was low because they will be more willing to buy American goods in this case.

Another factor in the economy affected by the exchange rates is the price level of goods. The lower the value of a certain currency in a country, the higher the prices eventually become in that country. This is because as the value of the U.S. dollar lowers, more American goods are demanded, and this makes the price increase because aggregate expenditures go up. While different factors in the economy are affected by the exchange rates, the exchange rates are also affected by some other factors in the economy.

An important influence on the exchange rates is interest rates. If the interest rates are higher in Japan than in the United States, more people will want to invest in Japanese securities. So Americans will exchange their dollars for yen, which increases the demand for yen. Then these newly acquired yen from the exchange of the U.S. dollars are used to buy the Japanese securities. This increase in demand of yen will eventually cause an increase in the price of yen and also a decrease in the value of the dollar. When the price of the yen rises it takes more dollars to buy Japanese goods, and the exchange rate will consequently rise. Currently, the exchange rate system is still a floating one, which is obvious by the daily changes in all of the exchange rates similar to this dollar/yen example.

But presently there is a little more control over the exchange rates from the central banks of the respective countries to prevent the major fluctuations that many citizens fear and to keep the economy as stable as possible. The following data was received from FRED. It submits data on the exchange rates between Australia, Canada, Mexico, Britain, and France all compared to 1 U.S. dollar. The first column is a comparison of exchange rates to the U.S. dollar to Australia.

The next column is the Canadian dollar to the U.S. dollar, and the last column is a comparison of the Mexican peso to the U.S. dollar. In the last chart, compares in the first column, the exchange rate between the U.S. dollar to the British pound.

Finally, in the last column, relates the French francs to the U.S. dollar. World trade now depends on managed floating exchange system. Governments act to stabilize their countries exchange rates by limiting imports, stimulating exports, or devaluating currencies. Floating exchange rates are the best system available to central banks at this time. This system is certainly not without flaws, but it is the only feasible choice. Governments will always desert a fixed rate system, either when their reserves run out or when domestic inflation or recession becomes too severe.

Bibliography Works Cited Corden, Max. Economic Policy, Exchange Rates, and the International System. Chicago: The University of Chicago Press, 1994. Einzig, Paul. The Case against Floating Exchanges. Great Britain: St. Martins Press Hasnat, Baban.

Exchange Rate Misalignment and Foreign Direct Investment. Atlantic Economic Journal June 1999: 235-236. Husted, Steven., and Michael Melvin. International Economics. New York: University Of Pittsburgh, 1997 FRED. Exchange Rates. Retrieved November 11, 1999 from the World Wide Web At Gwinn, Robert P. Exchange Rates.

The New Encyclopaedia Britannica. 1987 Ed. Economics Essays.