Discuss the advantages and disadvantages in having a managed exchange rate regime.

Advantages of a managed/fixed exchange rate

• Predictability and certainty

a) Fixed exchange rates make it simpler for importers and exporters to calculate earnings

b) Costs, revenues and profit margins are clear and predictable

c) This makes an incentive for firms to invest and households to engage in entrepreneurial activity.

Disadvantages of a managed/fixed exchange rate

• Loss of domestic monetary policy freedom

a) When a country commits to keeping a particular exchange rate, the central bank will have limited freedom in setting interest rates in order to affect the domestic economy. Interest is one of the tools which a central bank can use to keep a peg towards another currency, since higher interest rates attract foreign funds and thus enhanced demand for the domestic currency. Since the priority of the central bank must be to keep the exchange rate steady there is little room to set interest rates in order to kindle or deflate the domestic economy. There is a trade-off among having a fixed exchange rate and being able to set domestic monetary policy.