Question

What is meant by Fixed and Flexible exchange rates? Give arguments for and against it.

Hint:

Countries with flexible exchange rates benefit from policy flexibility but may face greater currency volatility. Fixed exchange rates provide stability but limit independent economic management.

Answer 1

An exchange rate is the value of one country's currency in terms of another currency. The exchange rate system can be broadly classified into two categories: Fixed Exchange Rate and Flexible Exchange Rate (also known as floating exchange rate). Fixed Exchange Rate: A Fixed Exchange Rate is a system where the value of a country's currency is pegged or tied to another major currency (such as the US dollar or euro) or a basket of currencies. The government or central bank intervenes in the foreign exchange market to maintain the currency's value within a narrow band. Advantages of Fixed Exchange Rate:
1. Stability and Predictability: Fixed exchange rates provide stability in international trade and investment, as businesses and investors can plan with greater certainty regarding future currency values. 2. Reduced Inflation: By pegging the currency to a low-inflation currency, the country can maintain lower inflation rates. 3. Boost to Trade: Fixed rates eliminate exchange rate risk, making exports and imports more predictable, which can boost international trade. 4. Foreign Investment Attraction: The stability of the exchange rate can attract foreign investors who are less concerned about currency fluctuations. Disadvantages of Fixed Exchange Rate:
1. Loss of Monetary Policy Independence: To maintain the fixed exchange rate, the central bank may need to adjust interest rates and undertake interventions in the foreign exchange market, which can limit the country's ability to conduct independent monetary policy. 2. Vulnerability to Speculation: Fixed exchange rates may lead to speculative attacks if investors believe the peg is unsustainable, forcing the government to devalue or revalue the currency. 3. Difficulty in Maintaining the Peg: If there are significant economic imbalances (such as large trade deficits), maintaining a fixed exchange rate can become challenging, requiring large foreign currency reserves or borrowing. Flexible (Floating) Exchange Rate: A Flexible Exchange Rate is determined by the market forces of supply and demand, with little or no government intervention. In this system, the currency value fluctuates freely based on market conditions, such as inflation rates, interest rates, and the balance of payments. Advantages of Flexible Exchange Rate:
1. Monetary Policy Independence: Countries with flexible exchange rates can use monetary policy more freely to adjust interest rates and control inflation, without the need to maintain a specific currency value. 2. Automatic Adjustment: The flexible exchange rate system automatically adjusts to changes in economic conditions. For example, if a country's trade deficit increases, its currency will depreciate, making exports cheaper and imports more expensive, thus improving the trade balance. 3. No Speculative Attacks: Since the currency is not fixed, there is less risk of speculative attacks on the currency, making it more resilient in times of crisis. Disadvantages of Flexible Exchange Rate:
1. Exchange Rate Volatility: Flexible exchange rates can be highly volatile, leading to uncertainty for businesses involved in international trade. Fluctuations in currency value can affect the profitability of exports and imports. 2. Inflationary Pressures: A depreciation of the currency can lead to inflation, as the cost of imports rises, which can negatively affect domestic consumers. 3. Potential for Market Misalignment: Sometimes, currency values can fluctuate wildly due to factors unrelated to the underlying economic fundamentals, such as speculation or geopolitical instability. Conclusion: - Fixed exchange rates provide stability but can restrict a country's economic flexibility, whereas flexible exchange rates offer more autonomy but may lead to volatility. - The choice between these systems depends on a country's economic conditions, trade relationships, and monetary policy goals.