A Report on Reasons why Governments Prefer Financial Systems featuring Essay

A Report on Reasons why Governments Prefer Financial Systems featuring Fixed - Essay Example On the other hand, a floating rate of exchange is the one that is moving and received currency depends on exchange time.To maintain their local exchange rate, central banks of European Union members bought and sold their own currency in foreign exchange markets, and in return, they acquired their pegged currency. For example, if the value of a single local unit currency is US$4, the central bank ensures that those dollars can be supplied in market by the country. High foreign reserve levels are required so as to maintain the rates (Eichengreen & Ricardo, 1999). High foreign reserve levels also ensure that there is good money supply thus preventing inflation/ deflation. An exchange rate refers to the rate at which one currency is exchanged for another. Therefore, it is the value of a country’s currency in terms of another. From 1870 to 1914, the global exchange rate was fixed. During that time, currency was likened to gold, implying that a local currency’s value was set at a fixed exchange rate that was determined in terms of gold ounces, that is, the gold standard (Eichengreen & Ricardo, 1999). This allowed free capital mobility and global stability in trade and currencies. The gold standard was abandoned when World War II started, but the end of the Second World War, the Breton Woods conference sought for efforts to stabilize the global economy and increasing global trade by establishing basic regulations and rules that governed international exchange. This led to the establishment of International Monetary Fund (IMF) for foreign trade promotion and monetary stability maintenance of countries and hence of the global economy. It was agreed that the exchange rate would be fixed, in terms of the US dollars, which was then pegged to gold (US$35 per ounce) (Obstfeld & Kenneth, 1995). This means that a currency’s value was directly converted in terms of its value to the US dollar. For example, to buy a euro, the Euros had to be converted into US dollars, and then into gold value. This peg was maintained till 1971, US dollar could not hold the pegged rate value of US$ 35per gold ounce. Since then, many governments adopted the floating rate system and attempts of returning to gold like a peg together with a global peg were completely abandoned. Why Governments Prefer Fixed/ Pegged Exchange Rates Governments prefer fixed exchange rates because they ensure economic stability, especially in current developing nations, where a country can decide to fix its currency in order to stabilize the atmosphere thus ensuring foreign investment. This is because a peg gives the investors their investment value, thus relieving them from fluctuation worries unlike under a float (Calvo, 2002). A pegged currency also helps in lowering inflation rates and generating demand, which further increases a currency’s stability confidence. However, fixed regimes can cause serious financial crises because it is hard to maintain a peg in the long r un. This was experienced in 1995 in Mexico, 1997 in Asia and Russia. Therefore, the governments could not meet the demands of a high value for their currencies to the peg resulting into overvaluing of their currencies. With panic and speculations, investors quickly removed their money out of these countries, and convert it to foreign currencies before the local currency was devalued against the peg. Eventually, foreign currencies became depleted. In Mexico, the government devalued the peso by 29.98%. Eventually, in Thailand, the government eventually allowed floating of