Bipolar Theory of Exchange Rate System

Introduction

The two-polarity theory of exchange rate systems is a theory which divides the exchange rate systems between two groups. The two groups are: fixed exchange rates and floating exchange rates. Fixed exchange rates are when central banks or governments take active measures to keep the value of their currency at a certain level, usually against a major trade currency such as the US dollar or the euro. Floating exchange rates, by contrast, are when the value of a currency is determined by the currency market whereby buyers and sellers of currency set its value through their trading on a day-to-day basis. This essay will explore the two polarities in more detail and discuss their implications for the global economy.

Analysis of Fixed Exchange Rates

Fixed exchange rates are seen as a more traditional system and one which is favoured by policy makers in countries with developing economies. By keeping the value of the domestic currency fixed and ‘pegged’ to a major currency, policy makers can ensure that their currency does not become too volatile or unfavourable in terms of international trade. This means that businesses in the country can be certain that their foreign exchange transactions will remain relatively unchanged regardless of macroeconomic events which could create instability in a floating exchange rate environment.

One of the main advantages of fixed exchange rates is that it helps to promote greater economic stability within a country. This is due to the fact that the currency can remain at a specific level and has a relatively gradual change with only minor fluctuations. Thus, businesses and individuals can plan their financial decisions with a high degree of certainty as to the relative value of their domestic and foreign earnings. In addition, governments also benefit from fixed exchange rates as they allow more accurate targeting of fiscal and monetary policies, which can result in a more effective macroeconomic management.

However, there are also some downsides to fix exchange rates. Firstly, they can inhibit the ability of businesses to adjust to changes in the global markets, as they are unable to take advantage of more favourable exchange rates when such become available. Furthermore, the external value of the domestic currency can become overvalued or undervalued in relation to its true value. This can lead to a lack of competitiveness in international trade, which can further erode the economy’s long-term prospects. Finally, there may also be incentives for governments to manipulate their currency’s value to gain a trade advantage, or simply to inflate their own currency’s value for political purposes.

Analysis of Floating Exchange Rates

Floating exchange rates are seen as a more modern system as they are based on market forces and thus much more volatile than a fixed exchange rate system. The value of the currency is determined by the relationship between supply and demand in the currency markets, with changes being evident on a day-to-day basis.

The main advantage of a floating exchange rate is that it allows the economy to adjust more quickly to changes in global markets, as the value of the currency can move much faster than would be possible in a fixed exchange rate system. This means that businesses can take advantage of more favourable exchange rates when they are available and enables them to remain competitive in global markets.

Furthermore, floating exchange rates also provide a greater degree of freedom for policy makers in terms of setting monetary and fiscal policies which are best suited to the domestic economic situation. This is because the currency market will respond quickly to any changes in policy, thus providing policy makers with greater control over the direction of the economy.

However, floating exchange rates also have some drawbacks. For example, they can be highly volatile, particularly when unexpected economic events occur or when geopolitical tensions increases. This can lead to increased uncertainty for businesses which have financial interests in foreign currencies, as well as domestic companies which take part in international trade. In addition, if market forces cause the value of a currency to fall, this can have a major detrimental effect on the economy as it can lead to a decrease in consumer purchasing power and an increase in prices.

Conclusion

The two-polarity theory of exchange rate systems can be useful in understanding the differences between fixed exchange rates and floating exchange rates. Fixed exchange rates are seen as a more traditional system and are favoured by policy makers in developing economies, as they can help to promote greater economic stability and certainty for businesses. On the other hand, floating exchange rates provide greater freedom for policy makers and allow businesses to take advantage of more favourable exchange rates when they are available. Both systems come with their own benefits and drawbacks and it is up to the policy makers in each country to decide which system is most appropriate for their own economic circumstances.

The exchange rate system includes two main approaches: floating exchange rates and fixed exchange rates. Each approach has its merits and drawbacks, but both come with risks.

Floating or flexible exchange rates are established through supply and demand in the open foreign exchange markets. Governments and central banks of countries do not directly control their exchange rate, which makes free floating exchange rates quite vulnerable to economic and political uncertainty. On the other hand, floating exchange rates allow traders and investors to better manage risk and increase their profits, as exchange rates will naturally move around due to supply and demand.

Fixed exchange rates are typically known as “pegged” and are determined by governments and central banks who typically keep the exchange rate steady. This allows governments to better manage their macroeconomic policies and provide more stability to their currency. The downside of fixed exchange rates, however, is that they can become overvalued or undervalued, leading to imbalances and creating potential problems.

In conclusion, there will always be pros and cons associated with the exchange rate system. It is, therefore, important to understand the risks of each approach. Governments and central banks need to balance the benefits and risks of each type of exchange rate system in order to make the best decision for their country.