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IAI Actuarial Core Principles · Business Economics · Balance of payments and exchange rates

Which of the following is a recognised disadvantage of a fixed exchange rate regime for a country compared with a floating regime?

A key disadvantage of a fixed regime is loss of monetary policy independence: interest rates must be directed at defending the parity rather than domestic inflation or output. Certainty for traders is a benefit, while automatic adjustment is a floating-rate feature.

  1. AGreater exchange rate uncertainty for exporters and importers
  2. BThe central bank loses the ability to set interest rates to meet domestic objectives, as policy must support the pegCorrect
  3. CThe exchange rate automatically corrects current account imbalances
  4. DForeign exchange reserves are never needed
  5. Exchange rate movements cannot be speculated against

Explanation

Defending a peg constrains monetary policy, since interest rates must be used to maintain the parity rather than to target domestic inflation or growth. Certainty for traders is an advantage of fixed rates. Automatic correction is a feature of floating, and reserves are needed to defend a peg.

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