A fixed exchange rate ties the country’s official currency exchange rate to another country’s currency, a basket of other currencies, or another measure of value, such as the price of gold. Under the fixed exchange rate, the government “aims to stabilize the exchange rate of the domestic currency by directly fixing its value to a more stable measure in a predetermined ratio” (Frieden, 2016, p. 75). Its benefits include stability, as the exchange rate does not fluctuate with market conditions, and easier trade and investments between the two currency areas (Hubbard & O’Brien, 2019). The disadvantages of the fixed exchange rate are that it prevents adjustments for currencies that become under- or over-valued and limits the extent to which central banks can adjust interest rates. To support a currency under the fixed exchange rate, a large pool of reserves is required.
Under the floating exchange rate, a currency’s value is determined through supply and demand, is relative to other currencies, and is allowed to fluctuate in response to foreign market events. The main economic advantage of the floating exchange rate is that it leaves the government free to pursue internal goals, and its adjustments work as a stabilizer to promote these aims (Hubbard & O’Brien, 2019). It automatically corrects any fluctuations in the balance of payments and allows the government to influence the external value of the domestic currency to their advantage and quickly address any possible crises (“Floating exchange rates,” n.d.). The main disadvantage of the floating exchange rate is its instability, with the day-to-day changes discouraging direct foreign investments and encouraging speculation.
The pegged exchange rate system incorporates the elements of floating and fixed exchange rate regimes. It pegs the country’s domestic currency to a stable foreign currency or a basket of currencies. An initial target exchange rate is agreed upon by the participating countries, and a fluctuation rate is set to determine acceptable deviations (“Fixed vs. pegged exchange rates,” n.d.). The main advantage of the pegged exchange rate is that it reduces the volatility of currencies used in developing economies and puts pressure on governments to be more disciplined in their monetary policy choices (“Fixed vs. pegged exchange rates,” n.d.)). It makes the exchange rate between the two countries constant and stable, eliminates fluctuations, and turns the currency into a safer investment (“Fixed vs. pegged exchange rates,” n.d.). However, it opens the possibility of investor speculation, which may affect the value of the currency, and requires a large number of reserves to maintain the stable rate.
Effects of Trade in the Open Economic
The four components of the gross domestic product (GDP) are personal consumption, business investment, government spending, and net exports. The GDP is calculated as the sum of these four variables and is defined as “the value of all the final goods and services produced in a country during a given time period” (Mankiw, 2014, p. 43). Consumption is the aggregate of all goods and services consumed in the country, while government spending is “the sum of all goods and services purchased by the government” (Mankiw, 2014, p. 43). Investment is the purchase of capital by firms or individual consumers. Net exports are calculated as imports subtracted from exports (Mankiw, 2014). The GDP only includes goods produced within the country and does not consider imported products.
A purchase of $1,000 worth of furniture manufactured in China is regarded as a personal consumption expenditure. It does not affect government spending and business investment because neither of them is involved in the transaction. It affects net exports as an accounting rather than an expenditure variable because its value is subtracted from the GDP to determine the net exports component of the GDP.
A purchase of $1,000 worth of furniture manufactured in China has a slight indirect influence on the nation’s GDP. The GDP increases with the purchase of domestic goods and services and is not directly affected by the purchase of imported items (Wolla, 2018). In order for the GDP to increase, “the total value of goods and services that domestic producers sell to foreign markets need to exceed the total value of foreign goods and services that domestic consumers buy” (Brock, 2019). When a country imports goods or services, buying them from foreign producers, the money spent on them leaves the economy, decreasing the GDP. If domestic consumers buy more foreign products than domestic producers sell to foreign markets, the GDP decreases significantly (Brock, 2019). Therefore, personal consumption expenditures do not have a direct influence on the GDP but insignificantly decrease it because of the money leaving the nation’s economy.
If a firm which sold the furniture is an American company based in China, the transaction’s impact on the GDP does not change significantly. The country’s GDP only includes goods produced within this country, meaning that “if a firm is located in one country but manufactures goods in another, those goods are counted as part of the foreign country’s GDP” (Mankiw, 2014, p. 43). In this case, the furniture produced in China by an American company is counted as part of China’s GDP and does not influence the GDP of the United State. Therefore, the transaction is not included in the net exports and only has a slight indirect influence on the country’s GDP.
Effects of Globalization and International Trade on the U.S. Economy
Free trade is a policy that does not put restrictions on imports or exports. It is generally considered beneficial because it allows consumers to buy better-quality products in larger quantities and at a lower cost. Free trade enhances efficiency and innovation, increases exports, provides a greater choice of goods, and generally improves the country’s economic well-being (“Free trade,” n.d.). It stimulates long-term economic growth by reducing production costs, encouraging large-scale production, creating international competition, and encouraging the interchange of knowledge and ideas between nations.
Although free trade provides a general net gain in economic welfare, there are groups within the country’s economy which are negatively affected by it. Free trade benefits consumers, exporters with a competitive advantage, and domestic firms who see higher demand due to consumers having more disposable income (Pettinger, 2018). It negatively affects domestic firms who are uncompetitive and lose out to cheaper imports, and workers who lose jobs in uncompetitive industries. The impact of free trade on domestic job creation policy is controversial, as it creates more jobs in export industries while reducing employment in uncompetitive industries.
Within the free trade policy, the U.S. exports and imports of goods and services are based on the principle of comparative advantage. The country imports goods, such as coffee and oil, from the nations specializing in the production of certain items, and exports sophisticated goods and investment opportunities. It allows the country to invest its capital, labor, and natural resources in the production that requires lower opportunity costs and higher profit margin.
Free trade is generally affected without any restrictions, although some countries still impose trade barriers on imported goods and services to protect their domestic industries. Advantages of trade protectionism include “the possibility of a better balance of trade and the protection of emerging domestic industries” (Pettinger, 2018). Disadvantages are a lack of consumer choice and reduced economic efficiency. For the U.S. economy, trade protectionism is considered beneficial in some areas, such as agriculture and the car industry, but is connected with a number of risks and disadvantages, such as an increase in consumer prices.
Another instrument used by the government to protect the country’s economy is currency devaluation and revaluation. They are official changes in the value of the domestic currency made in response to unusual market pressures. Devaluation, which is the downward adjustment in the official exchange rate, makes foreign products more expensive, discouraging imports (“Currency devaluation and revaluation,” n.d.). It helps to increase the country’s exports and decrease imports and may help to reduce the budget deficit. Revaluation, on the other hand, makes foreign products cheaper and increases imports.
One of the most extreme forms of currency manipulation is the currency war, which involves the country’s central bank deliberately lowering the value of its national currency. While providing a short-term comparative advantage for the country, it negatively affects international trade. Currency wars encourage investments in the nation’s assets while increasing the prices for importing goods. Overall, the U.S. economy is positively affected by globalization and international trade, which allow the government to use multiple instruments to regulate the currency rate, imports, and exports.
Brock, J. (2019). How international trade correlates to gross domestic product. PCB. Web.
Currency devaluation and revaluation. (n.d.). Federal Reserve Bank of New York. Web.
Fixed vs. pegged exchange rates. (n.d.). Corporate Finance Institute. Web.
Floating exchange rates: Advantages and disadvantages. (n.d.). Economics Discussion. Web.
Free trade: Advantages and disadvantages. (n.d.). Economics Discussion. Web.
Frieden, J. (2016). Currency politics: The political economy of exchange rate policy. Princeton University Press.
Hubbard, G., & O’Brien, P. (2019). Economics (7th ed.). Pearson.
Mankiw, G. (2014). Principles of Economics (7th ed.). Cengage Learning.
Pettinger, T. (2018). Who are the winners and losers from free trade? Economics Help. Web.
Wolla, S. (2018). How do imports affect GDP? Economic Research. Web.