For a fixed exchange rate system to work successfully, the government

For a fixed exchange rate system to work successfully, the government that oversees its operations must be able to make tight budget and monetary policies prevail from the beginning. Agree or disagree and explain why.

What will be an ideal response?

ANSWER

Answer: Under a fixed exchange rate system, there is a strong assumption that the source of the system’s power, the government of the country, will have enough power and strength to determine what is best for the system. A government that runs budget deficits year after year accompanied by an easy monetary policy is not likely to be able to maintain a commitment to a fixed exchange rate system. A government that is willing to start out without a strong commitment will also appear to observers and currency traders to be willing to make the exchange rate subservient to other national interests. Budget deficits and easy monetary policy annually send a signal to speculators that the government lacks commitment and they are more likely to attack the currency, making it even more doubtful of the government’s ability to continue to maintain the fixed exchange rate.