SUBMITTED TO SUBMITTED BY

Prof. ASHOK BHANSALI NIKHIL KUMAR OJHA

PGPBM (2010-12)

ISB&M; NOIDA
Question 1-What are the advantages and disadvantages of a fixed versus floating exchange rate
systems?

Answer: Floating exchange rate regimes are market determined exchange rates in which value of
currency fluctuates with market conditions. In the fixed rate regime, the central bank of country is
responsible for maintenance of exchange rate at predetermined price with the help of different
monetary policies.

The main economic advantage of floating exchange rates is that they leave the monetary and fiscal
authorities free to concentrate on internal goals such as employment, stable growth and commodities
prices because in this case free floating exchange rate works as an automatic stabilizer to control the
value of currency.

The main economic advantage of fixed exchange rates is that they promote global trade and investment
by gaining trust of corporate and investors as they know government is there to control all the risk
associated with exchange rates. This can be very important in long run growth.

A s given in the case, Singapore after getting independence from UK have three developmental
imperatives to counter-

1. Reduce unemployment
2. Promote industrialization
3. Become a globally competitive off-shore financial sector.

So they adopted policy of managing their exchange rates i.e. semi-fixed exchange rate regime, which
allows exchange rates to vary within a certain band which assured foreign investors that there is
government to take care of exchange rates, prices.

I would try to bring out disadvantages of fixed and floating exchange rates with the help of economic
conditions given in the case:

Floating Exchange rate:-

1. As discussed earlier, Singapore government has three development imperatives. By having

floating exchange rate government would not be able to control inflation. So this can hamper
their first two objectives to reduce unemployment and to promote industrialization.
2. Free floating Singapore Dollar (SGD) would become highly volatile in short run; leading to
misallocation of resources in long run.

Fixed Exchange Rate:-

Singapore economy is a more off shore financial market. So fixing its currency at a exchange
rate would mean aligning there currency to some other currency .But it’s not possible due to
divergence in business cycles of different countries. As we can see in the case of Hong Kong they
have fixed their currency against USD and their business cycle is aligned to Chinese business cycle. It
helped them a lot when everything was going well throughout the globe then Hong Kong was doing well
throughout all the sectors .But when Asian financial crisis hit the globe, then HK$ came under pressure,
because they want a tighter monetary policy at that point but their interest rates were lower as they
were aligned with USD. Hong Kong experienced severe deflation due to contraction in money supply.
Also investors feared that Hong Kong government might devalue HK$. Finally stock market fell by 25%
and when government tried to overcome this by increasing interest rates then they slipped into
recession.

Question 2:- What is real exchange rate?

Answer:- Real exchange rate is the measure in terms of ratio at which the any countries own
currency is equivalent to other currencies in terms of purchasing power. It is preferred over
nominal exchange rates as nominal rates only measures the ratio at which countries currency is
traded in spot market. It gives much clearer picture of any countries exchange rates.

Real Exchange Rate=Nominal exchange Rate-Inflation

Question 3:- What do you think determines exchange rates in short term, medium term and long
term?

Answer- Factors determining exchange rates

Short Run

1. Trend followed in the market.

2. How investor have positioned himself/herself.
3. Sentiments of investors.
4. Foreign investments.
5. Risk appetite of investor.
6. How option foreign markets have positioned themselves.
Medium Run
1. Real interest rate differentials.
2. Current account trends.
3. Capital Flows.
4. Monetary policy.
5. Fiscal Policy.
 6. Relative economic growth.
Long Run
1. Purchasing Power Parity.
2. Net Foreign Assets.
3. Productivity i.e. GDP.
4. Trends in terms of trades.
5. Savings/investment balance.

Question 4:-How do exchange rates interacts with trade balances, inflation rates and fiscal policies?

Answer-

Inflation
Country having lower inflation rate, the purchasing power related to that currency
decrease less relative to countries with higher inflation rate. So the value of money
decreases less as compared to other currencies. So all these relative works results into
higher exchange rates.
Interest rates, inflation and exchange rates are all highly correlated. By manipulating
interest rates, central banks exert influence over both inflation and exchange rates, as
we can see in case of Singapore as they have managed inflation below 2% throughout
last two decades just by managing their exchange rates in pre-decided band.

Trade balance
Trade Balance=Exports-Imports

Everything that impact imports and exports are determining factor of trade balance.
Exchange rate determines the prices of commodities traded. So it’s very important
factor in determining trade balance. If the price of a country's exports rises by a
greater rate than that of its imports, then trade have favorably improved for that
country. Trade surplus shows greater demand for the country's exports. This, in turn,
results in rising revenues from exports, which provides increased demand for the
country's currency (and an increase in the currency's value). And vice-versa happens
in case of trade deficit.

Fiscal Policies

Fiscal Policy is managing countries expenditures and revenue collection to influence

country’s economy. The main sources of revenues for government are taxation,
seigniorage, borrowing money, fiscal reserves and selling of assets.

We know value of currency is determined by exchange rates. Taxes are important

earning from trade and trade is directly related to exchange rates. So while making
fiscal policies countries must care about exchange rates. As Singapore was having
advantage of large savings by their citizens.

Question 5 How exchange rates do impacts firms?

Answer:- When domestic currency is valued more against foreign currency,it makes
import cheaper and exports expensive. So businesses having more import will be
flourishing and exports led businesses will not, and in vice versa situation just
opposite will happen to businesses.

Moreover, in simple words exchange rates are important factor in formulating

monetary and fiscal policies. These policies determine business environment of any
country. For example, if interest rates increase in India, then it affects the valuation of
all investments in our country i.e. if interest rate increases then returns increases on
investment. As investment increases in corporate, corporate will go for fresh and better
projects.