Irfan Arshad 1

Muhammad Irfan Arshad

Roll No: AX846575
Professor Dr. Syed Aamir Shah
LEVEL: MS (MANAGEMENT SCIENCES)
Date: 25
th
Sep 2014
INTERNATIONAL BUSINESS AND FINANCE (8702)
SEMESTER: SPRING 2014
ASSIGNMENT No. 2
(Units: 48)
ALLAMA IQBAL OPEN UNIVERSITY, ISLAMABAD
(Department of Business Administration)
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Question No 1: What is economic integration? Discuss its short run economic effects
for the member and non members in detail. Also discuss the reasons why it is not
successful among the developing countries.
Economic integration refers to agreements between countries in a geographic region to
reduce tariff and non-tariff barriers to the free flow of goods, services, and factors of
production between each other.
Types of regional economic integration:
Preferential trade agreement (PTA) provides lower barriers trade among participating
nations than trade with non member.
Free trade area (EFTA, NAFTA) eliminates all barriers to the trade of goods and
services among member countries. Each member maintains own level & form of
protection against non members.
Customs union (EEC) eliminates trade barriers between member countries and adopts a
common external trade policy consisting on duty-free movement of products/services,
Common external tariff to non members.
A common market has no barriers to trade between member countries, a common
external trade policy, and the free movement of the factors of production for example
MERCOSUR (Brazil, Argentina, Paraguay, and Uruguay) having Supranational
authority for joint economic policy making.
Economic union; EMU has the free flow of products and factors of production between
members, a common external trade policy, common central bank, a common
currency, a harmonized tax rate, and a common monetary and fiscal policy
A political union involves a central political apparatus that coordinates the economic,
social, and foreign policy of member states. EU is headed toward at least partial
political union, and the U.S. is an example of even closer political union.
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Short run effects of Economic Integration
1. Trade creation vs trade diversion
Trade creation higher priced domestic output replaced by lower priced
imports increases welfare
Trade diversion trade diverted from low cost to high cost supplier
decreases welfare
Trade Creation (Positive impact on member countries)
Replacement of domestic expensive goods results in net gain of JCM (Pdn component) AND
BHN (consumption component)
Trade Diversion (Negative impact on Non Member countries)
Lower cost imports from outside the customs union are replaced by higher cost
imports from member unions.
Preferential trade treatment result in the financing of inefficiency within a customs
union.
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Trade diverting customs union results in both trade creation and diversion and
strength depends on the relative strength.
Can increase or reduce welfare of members
Static Welfare effects
CJJ and BHH is the welfare gain from pure trade creation, while MNHJ is the
welfare loss from diverting the initial 30X(JH) of imports from lower cost Nation 1 to
higher cost Nation 3
2. Market extension: Efficient producers enjoy free access to national markets of all
member countries.
3. Temporary unemployment: When inefficient firms exit from the market, workers in
such firms become unemployed. Eventually, they need to move to other industries.
4. Increased Competition
5. Replacement of small national markets with a large supernational market
6. Reaping benefits of economies of scale and learning effects
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7. Increased political cooperation and reduced violent conflict.
Economic Integration among developing countries
The reasons usually mentioned why regional integration is unsuccessful in developing
countries include:
1. Similarity of their economic structure,
2. Uniform market size,
3. Lack of dynamism in their economic development
4. Lack of commitment.
5. Lack of opportunity
6. Lack of opportunity
7. Risk of divergence due to trade diversion
8. Agglomeration effects
9. Economic integration leads to Pareto-reallocation of the factors (labor and capital)
which move towards their better exploitation. Labor moves to area of higher wages,
while capital - to area with higher returns.
10. All countries gain from free trade and investment, regional economic integration is an
attempt to exploit the gains from free trade and investment
11. It implies a loss of national sovereignty
12. It allows firms to realize cost economies by centralizing production in those locations
where the mix of factor costs and skills is optimal
13. Regional economic integration is only beneficial if the amount of trade it creates
exceeds the amount it diverts
14. There is a risk of being shut out of the single market by the creation of a trade
fortress
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Question No 2: What are Multinational Corporations? Why and how they decide to invest
abroad.
Multinational Company (MNC) is a company that is registered and operates in more than
one country at a time. Generally the corporation has its headquarters in one country and
operates wholly or partially owned subsidiaries in other countries. Thus, companies that
have a joint venture abroad, established a foreign subsidiary or acquired an existing operation
in a foreign country are considered MNCs. Madura and Fox, describes three alternatives to
becoming a MNC.
1. A company simply chooses international trade by exporting its goods and/or imports
material or tools. The advantage of international trade is that it is relatively cheap to
pull out, if it turns out not to be profitable.
2. Via licensing a company allows other firms to produce, sell and market its products in
foreign markets.
3. A company chooses to become a franchisor. According to Madura and Fox a franchisor
provides a specialized sale or service strategy, support assistance and possibly an
initial investment in the franchise in exchange for a periodic fee.
Why Multinational Corporations invest abroad
According to OLI model, following three factors that are thought to spike foreign
investments:
Ownership Advantages (O) include low cost advantage, competitive factors,
monopolist advantages, privileges like access to scarce natural resources, patent
rights, brand name and advantages from innovation activities like technology,
knowledge broadly give to the international firm the choice to compete abroad
profitably. For example Coca-Cola has significant organizational advantage of
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trademark that is well-known and enough to sell soft-drinks in numerous countries
across the world.
Locational Advantages (L) include Economic advantages (factors of production,
transport and telecommunications costs, scope and size of the market); Political
advantages (Specific government policies that influence FDI, intra-firm trade
and international production); Social, cultural advantages (psychic distance
between the home and host country, language and cultural diversities, general
attitude towards foreigner ant the overall position towards free enterprise) :
Natural resources in Greenland are becoming easier to access.
Internalization Advantages believe that its ownership advantages are best
exploited internally rather than sold directly through spot markets or offered to
other firms through some contractual arrangement such as licensing, the
establishment of a joint venture or management contracting.
There is no proper mechanism that can not directly affect investment decisions of companies
but consideration of following points tend to face less uncertainty and higher expected rates
of return.
1. MNCs try to achieve efficiency by minimizing their cost and maximizing economies
of scale while reducing duplication.
2. They invest in different locations to get different advantages from host countries in
order to operate better in their home base.
3. Multinational companies are looking for the perfect mix of factors of production
including technology.
4. While labour costs and attributes of the workforce such as skill and educational
levels are critical variables of investment decision.
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5. The purchasing power of the market and proximity to other markets are taken into
consideration in taking the investment decision.
6. The type of investment such as joint venture or wholly owned subsidiaries highly
affects the investment decisions.
7. Market size and growth prospects of the host country, the availability of
infrastructure, reasonable levels of taxation and the overall stability of the tax regime,
stable political environment, as well as conditions that support physical and personal
security, legal framework and the rule of law and corruption and governance concerns
constitute the main concerns of MNCs in taking their decisions in developing
countries.
8. The motivation of MNCs for investing in developed countries differs from that for
investing in developed countries, since the return of investment is higher with its
risk premium. As an example, even though there have been improvements in the
situation, investors face problems with enforcing intellectual property rights and those
selling branded products often have to deal with counterfeits in China, which is the
main destination of MNCs investments.
9. Good governance, Political and commercial factors, the legal framework and rule of
law concepts are of high importance.
How MNEs decide to invest abroad.
As opposed to the existence of uncertainty in different investment environments, MNCs
expanded "and are still expanding "their operations in different parts of the world taking
different advantages of different countries. Similarly developing countries such as Asian
countries, Brazil, Indonesia, and Mexico have realized the impact of FDI on the development
of the country and they have been able to maintain a significant level of FDI inflows taking
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advantage of their resource factors. In this "race to attract more FDI", countries are trying
to set strategies to attract more FDI for example:
1. Liberalization of investment regimes.
2. Developing strategies in line with the consideration of comparative advantageous areas
i.e Asian countries have relatively low wage rates, Eastern European countries are
focused towards infrastructure enhancement.
3. Fiscal incentives constitute the other type of influential tools to attract FDI. The
incentives such as tax breaks and tax holidays, favourable utility usage fees, reduced
custom duties and foreign exchange restrictions, relaxed ownership controls, and
streamlined administrative procedures aim to create the best place in terms of FDI
attractiveness.
4. Additionally, there has been the development of enclave zones under an overall
national strategy. These zones have been employed "to bring in labour-intensive
manufacturing activities to absorb surplus labour, to experiment with a policy
instrument that has not been used before, and to facilitate the transition from a closed
economy to an open one".
Question No 3: What are the implications of Globalization for Pakistans Trade,
Foreign Direct Investment, and Transfer of Technology.
Through the adoption of globalization there are several neighboring countries of Pakistan
which have made them more developed, grown and successful nations amongst which
China is on the top and including India and Bangladesh as well. Pakistan has also shown
several positive intentions towards its cause but up till now they have not shown any
drastic change and development. For example, up until 1991, Pakistan was growing at twice
the rate of the Indian economy. However, that year, India decided to do away with the
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majority of their remaining trade barriers, opening up their borders to competitive markets
and surpassing Pakistan in terms of economic expansion. Pakistan has also been working on
this aspect seriously to remove poverty from the country and for that purpose they are also
opening their borders for the foreign trade so that through the positive use of globalization.
Implication of Globalization for Pakistans Trade
Throughout the past three decades Pakistans imports have exceeded its exports. Pakistans
exports stood at $ 18.45 billion by the year 2013, while its imports stood at around $ 3383
million, implying a trade deficit of $ 1548 million. However, the trade deficit as percentage of the
GDP has come down significantly from 12 per cent in 1980 to 3 per cent by 2013, as exports
have increased while at the same time imports have declined. During the eighties, Pakistans
exports recorded a high growth of 11.1 per cent per annum, as a result of which exports had
grown from 12 per cent of the GDP in 1980 to 16 per cent of the GDP by 1990. The growth in
exports fell to half that rate in the nineties, while imports grew by an annual average rate of just
0.7 per cent during this decade. The share of merchandise exports in total exports has been
steadily rising during the past three decades; merchandise exports accounted for about 96 per cent
of total exports.
Increasing trade integration requires a well-diversified export base, both geographically and
by product. Dependence on a few export products and markets increases the risks associated
with market fluctuations. Pakistans export base has however, not seen the level of export
diversification that is typical of a globalised economy during the past ten years after it opened
its economy with the introduction of liberalisation and trade reforms. It is still concentrated
on a few low value added commodities, namely the textiles and clothing products. Here it can
also be seen that the major part of Pakistans textile exports is of cotton yarn while the
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leading exporters of textile and clothing have increased their share of value addition. This
lack of export diversification has resulted in rising concentration indices during the 1990s.
Pakistan has also made progress in eliminating and reducing non-tariff barriers to trade.
Import licenses have been abolished for all goods except those on the negative list
1
or
restricted list
2
. The scope of lists specifying restricted/ prohibited imports has been sharply
reduced. Presently, there are only 32 products on the negative list and import of 28 products
is restricted because of health and safety reasons.
Implication of Globalization for Pakistans FDI
Pakistans efforts to integrate into the world economy have not only encompassed trade
reforms but also the liberalisation of the financial sector. The opening up of the domestic
financial markets is very important to attract increased levels of Foreign Direct Investment
(FDI). FDI flows to Pakistan have increased markedly during the 1990s. From an average of
$ 120 million in the 1980s, it reached an average of $ 483 million during the 90s and $ 4.6
billion in 2013. Despite the higher flows of FDI during the nineties, the FDI to GDP ratio for
Pakistan was considerably low in that time period although it had improved significantly
from the ratio during the 80s. However, cross country comparisons reveal that in 1980
Pakistan received 34.1 per cent of the FDI f lows to the South Asian region which had
declined to only 13.7 per cent by 1999. The World Bank provides data for Pakistan from
1970 to 2013. The average value for Pakistan during that period was 0.76 percent with
a minimum of -0.06 percent in 1973 and a maximum of 3.67 percent in 2007.
FDI flows to Pakistan have mostly gone to natural resource exploration mainly in the oil and
energy sector. FDI flows to export oriented industries have been limited in the case of
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Pakistan, e.g., by the mid nineties less than $ 100 million had been invested in the Karachi
Export Processing Zone since it was set up in the early 1980s (Ibid).
Pakistans performance is even more unimpressive when we compare its FDI inflows with
that of other developing countries. It is observed that in 1999, the average stock of inward
FDI as a percentage of GDP in developing countries is 28% while that of Pakistan is only
17%. The inward FDI stock of Pakistan is much lower than those of East Asian countries,
like Singapore and Malaysia. It could be argued that these East Asian economies have a long
history of opening and hosting FDI. But the recent FDI inflows in Pakistan are also lower
than that of newly opened economies, such as China and Vietnam. In South Asia, though
Pakistan has a higher ratio of FDI inward stock per GDP than India and Bangladesh, it is
lower than that of Sri Lanka, which started promoting FDI nearly at the same time as
Pakistan. In terms of annual inflows, since the early 1990s India has attracted far more FDI
than Pakistan or any other countries in the region.
Implication of Globalization for Pakistans Transfer of Technology
It is true that almost all developing economies face the scarcity of technology. Technology is
very essential to enhance the productivity of factor of production and alternatively for
economic growth. This is because the developing countries spend less on research and
development while developed countries heavily spend on R & D so high concentration of
technology is in the hand of developed counties. According to the Global Competitiveness
Report 2011-2012, Pakistan ranks at number 93 in term of Availability of latest technology
index while India ranks at 47, Turkey 52 and Sri Lanka 63. So dependence on foreign source
of Technology is very crucial and important for Pakistan.
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There are many channels through which Technology can be transferred from developed
countries. The direct import of Technology embodied machinery and intermediate goods is
one channel of transmission of Technology. Foreign direct investment by multinational
companies (MNCs) is another source of international Technology transmission. The MNCs
import not only Technological modern machinery but also the Ideas and knowledge
generated through R & D carried out in parent country. In addition there is movement of
employees or managerial talent from developed economies to low and middle income
economies when these countries open their economies.
To absorb the foreign technology brought by foreign investor, the absorption capacity of host
country matters. Most of studies use level of human capital as measure of absorption
capacity
1
.As without minimum level of skill or knowledge (absorptive capacity) the local
firms cannot get knowledge benefit of technology transmission through foreign direct
investment (UNCTAD, 2010).
2
Many studies have shown that foreign sources of Technology
are important contributor to productivity growth for the developed economies. Less
developed economies as they spend less on R & D and face scarcity of modern Technology.
The import of Technology or transmission of Technology from developed countries is key
question for their economic growth. There is lot of controversy regarding the Technology
transmission whether it is good or bad for developing countries. Some Economist argues that
more open economies have more ability to absorb technology generated in advanced
countries. Some economist like Coe and Helpman(1995) showed that transmission of
technology and related knowledge from developed counties to developing countries through
export and import will be more effective in economies with better and advanced education.
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Question No 4: Define FDI? Discuss with reference to Dunning Theory that how it takes
place? Also discuss why Pakistan has failed to attract FDI in spite of lucrative policies.
Foreign direct investment (FDI) refers to long term participation by a country A into country
B (in this case Pakistan). It usually involves participation in management, joint-venture,
transfer of technology and expertise. There are two types of FDI: inward foreign direct
investment and outward foreign direct investment, resulting in a net FDI inflow (positive or
negative).
Eclectic FDI theory John Dunning
To form a unified theory of Foreign Direct Investment- According to John Dunning, FDI
will occur when these conditions are satisfied: (OLI MODEL)
There is an Ownership advantage (O)- the foreign firm must own some unique competitive
advantage that overcomes the disadvantages of competing with the local firms on their home
turfs.
There is a Location advantage (L): Undertaking the business activity must be more profitable
in a foreign location than undertaking it in a domestic location.
There is a Internalization advantage (I): the firm must benefit more from controlling the
foreign business activity than from hiring an independent local company to provide the
service.
Five Stage Theory - John Dunning
Stage 1: Low incoming FDI, but foreign companies are beginning to discover the advantages
of the country; No outgoing FDI no specific advantages owned by the domestic firms.
Stage 2: Growing incoming FDI do the advantages of the country - especially the low labour
costs; The standards of living are rising which is drawing more foreign companies to the
country; Still low outgoing FDI.
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Stage 3: Still strong incoming FDI, but their nature is changing due to the rising wages; The
outgoing FDI are taking off as domestic companies are getting stronger and develop their
competitive advantages
Stage 4: Strong outgoing FDI seeking advantages abroad (low labour costs)
Stage 5: Investment decisions are based on the strategies of TNCs; The flows of outgoing
and incoming FDI come into equilibrium
Why Pakistan Failed to Attract FDI
Foreign Direct Investment (FDI) has been instrumental in the development of the country. The
presence of foreign companies in Pakistan predates the inception of country. Pakistan was
among the first few countries in the region to open up the market in early nineties. Now the
foreign investors can virtually invest in any sector except a few. Opening up of market and
initiation of process of privatisation has made Pakistan a center of attraction. Foreign
investment came in large volume, both as FDI and as portfolio funds. The FDI inflow to
Pakistan in 1992-93 was US$ 307 million and exceeded US$ one billion in 1995-96.
However, since then, it has been registering a constant downward trend. With a growth rate
of less than four percent of GDP, the unemployment rate crossing 6.6 percent, the current
account deficit above seven percent of GDP, inflation ranging close to 10 percent and the
rupee rapidly losing its value, Pakistan has lost attraction for foreign investors.
Global economic slowdown is one of the important reasons for the drop in the foreign direct
investment. The economies of the United States and the Europe are experiencing a
contraction in their GDP growth. The Eurozone is in a deep recession due to debt crisis.
Therefore, international investors are reluctant to continue with the cross-border investment.
The fear of default came only because disbursement of funds from multilateral lenders was
suspended. They also say that the lenders will not allow Pakistan to commit default because:
"Pakistan has been prompt and current on all its debt serving obligations and no lender wants
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to penalise its customer, if it faces any problem. These lenders are still trying to workout a
bailout package but the GoP has to come at terms. The only thing these lenders are worried
about is the ability of Pakistan to meet its debt serving obligations. Initially, fall in the FDI
flows to Pakistan was considered to be in line with the global trend as most of the countries in
the region were facing similar situation. While the FDI flows to a number of regional
countries have resumed recently, they are yet to recover in case of Pakistan. This suggests
that the country needs to make more efforts to attract foreign direct investment, especially
when the debt inflows are also low.
Inconsistent Government policies are causing major hurdles for foreign investors. Despite
claims of liberal investment policies, new entrants face problems as the government revises
its policies every now and then, particularly by imposing different slabs of taxes and tariffs
on different categories aimed at protecting sectors such as the automobile industry. Pakistan
slipped further down the order due to difficulties in starting a business, dealing with permits,
getting credit, paying taxes and a delay in resolving insolvency. Another chief executive once
said: "Give me the worst policy I am still willing to work in Pakistan but the only assurance I
need is the implementation of policies in true letter and spirit.Instead of wasting our energies
on unresponsive India we should look at other regional countries like Bangladesh, Sri Lanka,
Afghanistan and China.
Macroeconomic instability also leads to fall in FDI. The government has failed to introduce
reforms required to stimulate economic growth. Poor structural reforms in the energy sector
and public finances, budget deficit have a negative trend. The government was supposed to
implement a reformed general sales tax (RGST) to generate additional tax revenues for the
financing of the budget deficit but no development took place on this front. The
governments inability to do so is a clear sign of its poor economic governance. Similarly
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poverty, unemployment and inflation are getting high day by day. The government has failed
to evolve any policy to achieve fiscal austerity and private sector growth.
Volatile political environment dwindles the attraction of foreign investor. Pakistan has
experienced political instability, including assassinations, bombings, sit-ins, demonstrations,
violence, Civil unrest, strikes. Political instability breeds uncertainty regarding continuity and
the future economic policies of a country, with the result that investment and productivity
wither and firms and markets, reduces hours worked and bottoms out growth.
Corruption in public funds also tends to discourage foreign investment. Corrupt practices
are more evident by the high profile government officials in the ventures / contracts of
projects of strategic significance. Massive corruption in such projects and delaying tracts
shake investors confidence. There is need of transparency in government accounts and
stability in the macroeconomic policies along with sound regulatory environment to foster
domestic private and foreign investments.
Dismal security and law and order situation has scared away investors. FDI cannot be
encouraged in a worsening law-and-order situation. The rise in suicide attacks and counter-
terror operations in Pakistan led to a flight of capital that peaked in 2009. The situation won't
improve until the government remedies the security and law and order situation.
Poor infrastructure facilities like communications, roadways, transportation, highways and
ports etc are limiting the interest of foreign investor. Cost of doing business in Pakistan has
increased tremendously due to lack of infrastructure facilities putting strains on the growth of
trade and industrial activities.
Energy crisis is also responsible for declining FDI. The electricity shortage, which assumed
dangerous proportions during last couple of years, has also been responsible for the increase
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in the cost of doing business. Energy is pivotal for running all other resources and crisis of
energy directly influences all other sectors of the economy and reduces attraction and
incentive for foreign investor.
Besides governance at state level we should improve corporate governance in the private
sector. FDI must work for both the investor and the country. We should restore the
confidence of the investors and build back the trust by opening fresh dialogues with investors
to arrive at a win-win situation. Concentration of ownership in corporate sector in a single
family remains mired in high debt, poor ethics and governance, and low market
capitalisation. Pakistan needs to improve its ranking in ease of doing business. Local
entrepreneurs have to be convinced that the conditions are conducive for investment in the
country. Any foreign investors will look only at the sort of profit being made by overseas
companies operating in the country to make a decision.
Question No 5: Differentiate between fixed and floating exchange rates. Also discuss
their merits and demerits.
A fixed exchange rate denotes a nominal exchange rate that is set firmly by the monetary
authority with respect to a foreign currency or a basket of foreign currencies. A metallic
standard leads to fixed exchange rates. In a gold standard, each country determines the gold
parity of its currency, which fixes the exchange rates between countries. In a reserve currency
system, the reserve currency has a gold parity, and all other currencies are pegged to the
reserve currency, which also leads to fixed exchange rates. Often countries join a semi-fixed
exchange rate, where the currency can fluctuate within a small target level. For example, the
European Exchange Rate Mechanism ERM was a semi fixed exchange rate system.
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Advantages of Fixed Exchange Rate
1. Avoid Currency Fluctuations. If the value of currencies fluctuate
significantly this can cause problems for firms engaged in trade. For example if a firm
is exporting to the US, a rapid appreciation in sterling would make its exports
uncompetitive and therefore may go out of business. If a firm relied on imported raw
materials a devaluation would increase the costs of imports and would reduce
profitability
2. Stability encourages investment. The uncertainty of exchange rate
fluctuations can reduce the incentive for firms to invest in export capacity. Some
Japanese firms have said that the UKs reluctance to join the Euro and provide a
stable exchange rates maker the UK a less desirable place to invest.
3. Keep inflation Low. Governments who allow their exchange rate to devalue
may cause inflationary pressures to occur. This is because AD increases, import prices
increase and firms have less incentive to cut costs.
4. A rapid appreciation in the exchange rate will badly effect manufacturing
firms who export, this may also cause a worsening of the current account.
5. Joining a fixed exchange rate may cause inflationary expectations to be lower
Disadvantage of Fixed Exchange Rates
1. Conflict with other objectives. To maintain a fixed level of the exchange rate
may conflict with other macroeconomic objectives. If a currency is falling below its
band the government will have to intervene. For example most effective way to
increase the value of a currency is to raise interest rates. However higher interest rates
will cause lower AD and economic growth, if the economy is growing slowly this
may cause a recession and rising unemployment
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2. Less Flexibility. It is difficult to respond to temporary shocks. For example an
oil importer may face a balance of payments deficit if oil price increases, but in a
fixed exchange rate there is little chance to devalue.
3. Join at the Wrong Rate. It is difficult to know the right rate to join at. If the
rate is too high, it will make exports uncompetitive. If it is too low, it could cause
inflation.
4. Current Account Imbalances. Fixed exchange rates can lead to current
account imbalances. For example, an overvalued exchange rate could cause a current
account deficit.
By contrast, a floating exchange rate is determined in foreign exchange markets depending
on demand and supply, and it generally fluctuates constantly. With floating exchange rates
the value of currency at any moment is determined by what people are willing to pay for it.
Appropriate for medium and large industrialized countries and some emerging market
economies that are relatively closed to international trade but fully integrated in the global
capital markets, and have diversified production and trade, a deep and broad financial sector,
and strong prudential standards.
Advantages of Floating Exchange rate
1. In theory there is an automatic mechanism to restore equilibrium to the
balance of payments. If a country is importing goods and services of a greater value
than it is exporting, the supply of its currency will exceed demand for it so the
currency will depreciate. This depreciation makes its exports cheaper and its imports
more expensive and so sets it on the way to having equal imports and exports.
2. If a government has a policy of a floating exchange rate, it does not need to
hold large reserves of foreign currency with which to adjust the exchange rate by
buying and selling its own currency.
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3. The government, since it is not concentrating on the exchange rate, is free to
concentrate on other policy objectives and goals.
4. Countries with low inflation rates, if they have a floating exchange rate, do not
import inflation from other countries as they would under fixed exchange rates.
Disadvantages of floating exchange rate:
1. High short-term volatility (excessive fluctations may be dampened in the case
of lightly managed float).
2. Large medium-term swings only weakly related to economic fundamentals.
3. High possibility of misalignment.
4. Discretion in monetary policy may create inflationary bias.
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Williamson J., & Milner, C. (1997). The World Economy. UK: Harvester Wheatsheaf.
Krugman, P., & Obstfeld (1997). International Economics: Theory and Policy. Singapore:
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Plesis, S. P. J. (1987). International Economics. UK: Butterworth.
Hodgson, J., & Herander, M. (1987). International Economic Relations (International
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