I need some help in this question, thanks.
Suppose that a Home country has many trading partners and each
trading partner has its own currency.
(a) If each trading partner allows its currency to float, is it possible for
Home to fix its exchange rate against all of its trading partners?
(b) If Home wishes to reduce the variability of its effective exchange rate, what kind of exchange rate regime might it choose?
a) could only work if the Home country was extremely large, relative to the sum of all the other countries. Otherwise you would have a knife-edge problem; either all the other countries would hold the Home contries currency or none of them would. For more info, google "Walrus Law"
b) It could express its currency in terms of a precious commodity (e.g., gold). Google the Gold Standard
Certainly! I'd be happy to help you with this question.
Let's break down the question into two parts:
(a) If each trading partner allows its currency to float, is it possible for Home to fix its exchange rate against all of its trading partners?
In this scenario, where each trading partner allows its currency to float, it becomes difficult for the Home country to fix its exchange rate against all of its trading partners. When currencies are floating, their values are determined by the foreign exchange market based on supply and demand factors. As a result, exchange rates between currencies can fluctuate over time.
To fix the exchange rate against each trading partner, the Home country typically needs to enter into bilateral agreements with each partner to establish a fixed exchange rate relationship. This requires significant coordination and ongoing management, which can become complicated when there are multiple trading partners with their own floating currencies. Therefore, it is not practically feasible for Home to fix its exchange rate against all of its trading partners if each partner allows its currency to float.
(b) If Home wishes to reduce the variability of its effective exchange rate, what kind of exchange rate regime might it choose?
To reduce the variability of its effective exchange rate, Home might consider adopting a fixed or pegged exchange rate regime. Under a fixed exchange rate regime, a country's currency value is fixed or pegged to another currency, a basket of currencies, or some external standard like gold.
By fixing its exchange rate, the Home country can stabilize its currency's value against fluctuations in the foreign exchange market. This can help reduce the uncertainty and variability associated with exchange rate movements, which can benefit trade and investment activities.
However, it's important to note that maintaining a fixed exchange rate requires active management and potential intervention by the Home country's central bank or monetary authorities. They would need to monitor and adjust their currency's value to ensure it remains aligned with the chosen reference currency or standard.
I hope this explanation helps you understand the concepts and answers your question. If you have any further doubts or need more clarification, feel free to ask!