A floating exchange duty is also referred to as a fluctuating rate, and it allows the value of a currency to change according to a foreign exchange market. An example of a currency operating in this state is the dollar (Papadia and Bruegel, 2017). Many countries prefer this exchange rate system because it easily adjusts to fluctuating economic circumstances, although it is vulnerable to unpredictable eventualities. On the other hand, governments maintain a constant currency value against a particular commodity or currency using a fixed exchange rate regime.
The central bank of a specific state, especially with small economies whose external trade is the primary contributor of their GDP, remains committed to selling and buying currencies at fixed prices (Wolfson, 2002, p. 398). This report is directed to the government of Italy, explaining the theoretical basis for alternative exchange rate regimes and why they might change over time. It also contains an analysis of the historical trend/association of the exchange rate and GDP growth and unemployment throughout Eurozone membership. Lastly, the report uses critically evaluates the factors influencing the decision to adopt a fixed or floating exchange rate.
Historical Analysis of Exchange Rates and Association with GDP and Unemployment
Italy’s economy is listed among the top ten globally, with a structure relying primarily on manufacturing and services. Its service sector contributes three-quarters of the country’s GDP, and it comprises approximately 70% of employed people in Italy. For the last two decades, the leading contributors in the services sector have been retail sales, wholesale, and transportation. Italy experienced a tremendous change in the economic structure after World War II, when small and medium-sized enterprises emerged, especially in export-related processes. In 1999, the country adopted the Euro, and it joined the European Monetary Union.
According to Papadia and Bruegel (2017), Italy has had a slow growth rate per head since the introduction of the Euro compared with other periphery countries such as Spain, Germany, and France have had significant growth rates. This experience is the first indicator of the poor performance of Italy since the onset of the Eurozone era. Figure 1 and Figure 2 show Italy’s GDP and unemployment changes after the Eurozone era.
Various factors affect Gross Domestic Product (GDP) and unemployment. An analysis done by an economist and a scholar showed that a 1% GDP decrease would result in more than a 2% increase in unemployment (Altunöz, 2019, p. 198). The relationship between GDP and unemployment is explained by the law of economic change Okun’s law, which describes the relationship between economic growth and unemployment. The law articulates that for a country to achieve a 1% employment increase, the government must continuously grow gross domestic product at four percent for one year. However, the law has transformed following the great recession. During the recession, a rise in unemployment was reported from a decrease in GDP, which was more than Okun’s prediction.
In Italy, a 0.5% GDP decrease resulted in a 3% increase in the unemployment rate. According to Okun’s law, a 0.5 percent decrease in GDP should have resulted in a 1.5 percent unemployment rise (Altunöz, 2019, p. 198). A slight reduction in unemployment results in a significant increase in unemployment which is higher than the predicted rise in Okun’s law. A growth of 2% in GDP will result in a 1% decrease in unemployment (Altunöz, 2019, p. 200). These changes have shown the great recession in Okun’s law of economic growth and unemployment. The analysis shows a significant deviation in the relation between GDP and unemployment. Changes in population and unemployment ratio have made it challenging to predict the unemployment rate in the future based on the unemployment rate.
The relationship between unemployment and Gross Domestic Product (GDP) brings forward some significant factors that lead to high unemployment rates worldwide. The assumptions involved while predicting future unemployment and GDP growth may affect the government’s efforts to fight unemployment, especially unemployment amongst youth (Corsetti et al., 2017). GDP shows the total value of the goods produced in a country within a specified period. Growth in a gross domestic product indicates a thriving economy in a country. When a country is experiencing an increase in production, there is a decrease in unemployment because more people will be involved in the production process. The total value of production will reflect on per capita income.
The Theoretical Basis for Alternative Exchange Rate Regimes, and Why they Might Change Over Time
The choice for the exchange rate regime is the sole responsibility of a country. The impossible trinity principle articulates that a country needs an exchange rate that ensures simultaneous monetary policy and capital mobility. A fixed interest rate has a significant double advantage regarding a floating exchange rate. The stabilization of a fixed exchange rate can lead to a successful trade between two countries (Papadia and Bruegel, 2017). Trade of assets is made more accessible because there is a defined exchange rate to determine the total cost of the commodities.
Additionally, a fixed exchange rate can be applied to uphold a stable monetary policy of a country. Maintaining a standard monetary policy is critical for a country that aims to reduce inflation impacts. However, this exchange rate regime is rigid and does not allow any flexibility to deal with unforeseen changes in the economy or recessions. This explains why many countries adopt exchange rate regimes with both extremes.
Italy adopted a floating exchange rate regime to strengthen its currency. Compared to other countries, this was a common trend towards ensuring the stability of monetary stability (Papadia and Bruegel, 2017). Over a decade now, European Monetary Union (EMU) has experienced significant development.
The successful development of EMU has brought the need to revisit the importance of fixed and floating exchange rate regimes. The concerns on the exchange rate regimes are brought by inflation brought by the two governments (ElMasry, 2021, p. 34). Some researchers have emphasized the relationship between fixed exchange rate and floating exchange rate and how they influence a country’s inflation. The research paper has identified the floating exchange rate to have a high inflation persistence compared to the fixed exchange rate regime. Floating exchange rates allow differential on inflation and eliminate losses on external competitiveness.
Additionally, exchange rate regimes have a close relationship with convergence in inflation and price rates. Theoretically, a fixed exchange regulates prices across various countries. The countries do not have the independence to control their costs which might provoke inflation or lead to a trade deficit (ElMasry, 2021, p. 45). The monetary price disequilibrium will be reported because the foreign exchange and importation of goods are not stable. Further, on the floating regime, economic policies and prices are given autonomy to evolve independently across the countries. The prices are changed using the nominal exchange rates, which are applied in different countries.
In relation amongst Italy, Spain, and United Kingdom over a decade ago, the data shows the adoption of the exchange rate regime in Italy and its impact on its economy. Lira has had a volatile value for more than three decades. The Italian currency is referred to be a weak currency compared to other strong currencies. The weakness of the Lira has advantages and disadvantages to the Italian economy. Importation of goods using a dollar is expensive for Italy.
On the other hand, the weakness of the Lira has increased the exportation of products from Italy. Exports are appealing to investors because of the low prices attached to the commodities. Conquering the foreign market is attributed to the low cost of production, which attracts potential investors. Italy taking part in European Economic Community (EEC) did not serve the intended purpose of saving the Lira currency (ElMasry, 2021, p.45). The Lira had no option other than withdrawing from the member state’s fixed exchange rate.
The withdrawal forced the government to devalue its currency to attract foreign investors and boost exports. The devaluation of the currency led to beautiful results, which resulted in increased exports. Consumers from the United States of America were pleased to enjoy the boom of their currency and the low prices from Italy. Due to Lira instability, Euro was introduced in 2002 to compete favorably with the dollar, which was significantly successful (Thahara et al., 2020).
A fixed exchange rate was adopted to enhance the competitiveness of the Euro with other global currencies. The Italian government enhanced public participation before doing away with the traditional Lira, which did not show economic development. The increased volume of trades and increased companies results from choosing the best exchange rate regime.
The exchange rate regime of a country might change over time. The change is attributed to various factors which affect the economy in a country. The factors are either external or external. The internal factors influence the choice of the exchange rate regime, which is within the country. External factors are the factors that are beyond the control of the country. External pressure from other global currencies can abandon the local currency and adopt new money that will compete favorably with other strong currencies (Papadia and Bruegel, 2017). Additionally, regulations and economic resections lead to a change of the exchange rate regime. Every country must review its exchange rates and adopt monetary policies to save its economy and compete with other leading nations.
Factors Influencing the Decision to Adopt a Fixed or Floating Exchange Rate
As various stakeholders take initiatives to ensure a stable global economy, multiple factors influence different countries’ best exchange rate regimes. The stability of the exchange rate regime is paramount to ensuring a tough economy. Fixed and floating exchange rates are the main regimes adopted by various countries (Thahara et al., 2020). The decision to adopt either of the exchange rate regimes is determined by the advantages and disadvantages associated with each government. The central bank of a given country will adopt a power that can facilitate economic development. The local currency should be predetermined to have autonomy over the foreign currencies to avoid inflation and hiked the price of commodities.
If a country wants to have the autonomy and internal control to pursue internal goals, it will choose a floating exchange rate. The exchange rate regime gives the local authority autonomy to work on its internal purposes and policies. The plans may include full employment, price control, and fiscal economic growth. An adjustment of the exchange rates will enable the local country to achieve the set goals (Thahara et al., 2020). The goals might differ from one country to the other, which influences the decision on the exchange rate regime to be adopted.
On the other hand, a country that aims to promote international will adopt a fixed exchange rate regime. Developing nations depend on other developed countries to accelerate growth; such a country should adopt an exchange rate regime that conforms with international standards. The decision to choose whether to adopt fixed or floating exchange rates will depend on how the country is dependent or independent on other countries.
A country with high reliability on its neighbors for trade and economic stability will adopt a fixed interest rate to work with neighboring countries. Such countries have little monetary independence (Corsetti et al., 2017). On the other hand, a country with economic freedom and unique shocks will adopt a floating exchange rate that will promote macroeconomic growth and stability of the local economy. Therefore, the government will determine the applicable exchange rate based on its macroeconomic. The adopted exchange rate should promote the country’s economy and uphold the local authority’s economic agenda.
Summing up, the exchange rate regime is critical in stabilizing an economy. It can be influential on economic growth via increased productivity and investment. A fixed administration is associated with high investment, while the floating regime has accelerated development and growth. The tax regime adopted should have the ability to transform the country’s economy and consider the goals of a nation. The macroeconomic and microeconomic policy of a government should be tied to the regime adopted by a country. There is no specific regime that can serve all the nations; each country should adopt a rule which suits its needs.
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