IF-Merits and Demerits of Fixed and Flexible Exchange rate systems

A nation’s choice as to which currency regime to follow reflects national priorities about all factors of the economy, including inflation, unemployment, interest rate levels, trade balances, and economic growth. The choice between fixed and flexible rates may change over time as priorities change. At the risk of over-generalizing, the following points partly explain why countries pursue certain exchange rate regimes. They are based on the premise that, other things being equal, countries would prefer fixed exchanges rates.

·          Fixed rates provide stability in international prices for the conduct of trade. Stable prices aid in the growth of international trade lessens risks for all businesses.

·          Fixed exchange rates are inherently anti-inflationary, requiring the country to follow restrictive monetary and fiscal policies. This restrictiveness, however, can often be a burden to a country wishing to pursue policies that alleviate continuing internal economic problems, such as high unemployment or slow economic growth.

·          Fixed exchange rate regimes necessitate that central banks maintain large quantities of international reserves (hard currencies and gold) for use in the occasional defense of the fixed rate. An international currency markets have grown rapidly in size and volume, increasing reserve holdings has become a significant burden to many nations.

·         Fixed rates, once in place, can be maintained at rates that are inconsistent with economic fundamentals. As the structure of a nation’s economy changes and its trade relationships and balances evolve, the exchange rate itself should change. Flexible exchange rates allow this to happen gradually and efficiently, but fixed rates must be changed administratively- usually too late, too highly publicized, and too large a one-time cost to the nation’s economic health.

The advantages of the flexible exchange rate system include: (I) automatic achievement of balance of payments equilibrium and (ii) maintenance of national policy autonomy.

If exchange rates are fluctuating randomly, that may discourage international trade and encourage market segmentation. This, in turn, may lead to suboptimal allocation of resources.

Economic agents can hedge exchange risk by means of forward contracts and other techniques. They don’t have to bear it if they choose not to. In addition, under a fixed exchange rate regime, governments often restrict international trade in order to maintain the exchange rate. This is a self-defeating measure.