RESEARCH ASSIGNMENT- INTERNATIONAL FINANCIAL MANAGEMENT

Q. 1 Both fixed and floating rates claim to promote exchange rate stability while controlling
inflation. Is it possible for these two divergent systems to achieve the same goals?
ANSWER
Exchange rates express the value of one country's currency in relation to the value of another country's
currency. The rates play an important part in economics, affecting the balance of trade between nations
and influencing investment strategies.
Exchange rates are the rates at which the currency of one country can be exchanged for the currency
of another. Suppose the exchange rate between dollars and Euros was 2 Euros per dollar (always state
exchange rates with the foreign currency as a multiple of the dollar). If you walked into an American
bank and handed over $15, you would receive 30 Euros. Now suppose that the exchange rate changed
to 3 Euros per dollar. If you went to that same bank, they would give you 45 Euros for your $15.
Significance
Exchange rates can be useful if you're planning a vacation or want to wire money to friends. But it's
also important to businesses when they are trying to determine whether or not to invest in a foreign
country and how much. Workers are often wary of taking jobs in countries whose exchange rates
fluctuate often and by large amounts. To understand this concern imagine you are back at the bank.
You have your 45 Euros in exchange for $15. If the exchange rate stays at 3 Euros per dollar you could
get back your $15. But suppose after you made your first exchange, the rate went to 6 Euros per dollar.
When you go to trade back to dollars, you will only get $7.50. If you can image this happening with
millions of dollars, you can understand why even small fluctuations in exchange rates would cause
concern for investors.
Methods
Countries, especially developing ones, pursue stable exchange rates to attract foreign capital. They
usually accomplish this by fixing their currencies to that of a more stable country, a practice called
pegging. A country's central bank may increase or decrease the money supply to maintain this rate.
Many countries have their currencies pegged to the U.S. dollar, but some such as China and Kuwait
have dropped the connection in recent years as the dollar has lost strength.
Theories/Speculation
Stable exchange rates generally are viewed as favorable, but there can be drawbacks. An economics
principle called the Mundell-Flemming Trilemma states that countries have three economic goals: (1)
stable exchange rates, (2) free movement of capital and (3) independent money supply. The Trilemma
states that it is only possible to have two of these goals at the same time. The trend in the post-World
War II economic system has been to have (1) and (2) at the expense of (3).

Warning
Preoccupation with exchange rate stability can exacerbate other economic problems. In the late
1990s, Argentina had inflation problems that could have been eased if the government had adjusted the
money supply. But this strategy was not pursued partly because of concerns about exchange rate
stability.
A fixed exchange rate is a country's exchange rate regime under which the government or central
bank ties the official exchange rate to another country's currency or to the price of gold. The purpose of
a fixed exchange rate system is to maintain a country's currency value within a very narrow band.

A floating exchange rate or fluctuating exchange rate is a type of exchange-rateregime in which a

currency's value is allowed to fluctuate in response to foreign-exchange market mechanisms. A
currency that uses a floating exchange rate is known as a floating currency.

It is not logical for both fixed and floating rates to be able to promote exchange-rate stability while
controlling inflation because the two systems are so divergent. Fixed rates might have been able to
partially accomplish these goals at one time when conditions were favorable. But fixed rates are no
longer effective because such conditions as high levels of employment and low and fairly uniform rates
of inflation no longer exist today.