Flexible and Fixed Exchange Rate Systems, Merits and Demerits

Any country's choice between flexible and fixed exchange rate systems is a critical decision influencing its economic stability, trade, and monetary policy. Each system has its advantages and disadvantages that can impact a nation's economic performance and integration into the global economy. Flexible exchange rates allow for automatic adjustment to market conditions, offering greater policy autonomy but at the cost of potential volatility.

What Is Fixed Exchange Rate System?

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Fixed Exchange Rate System Merits

• Stability and Predictability : Fixed exchange rates provide stability and predictability for businesses engaged in international trade. Knowing that exchange rates won't fluctuate significantly creates a favourable environment for planning.
• Inflation Control : Fixed exchange rates can help control inflation by limiting the central bank's ability to print excessive money to finance government deficits.
• Exchange Rate Risk Mitigation : Businesses and investors can more effectively hedge against exchange rate risk in a fixed exchange rate system because the rates are stable.
• Promotes Trade and Investment : Fixed exchange rates can promote international trade and foreign direct investment by reducing currency risk for companies.

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Fixed Exchange Rate System Demerits

• Limited Policy Autonomy : Countries with fixed exchange rates have limited control over their domestic monetary policy. They must maintain currency reserves to defend the fixed rate, which can restrict their ability to pursue independent monetary policies.
• Vulnerability to Speculation : Fixed exchange rates can make a country vulnerable to speculative attacks by investors who bet against the currency's peg. In defence, the central bank may deplete its foreign exchange reserves.
• External Shocks : Fixed exchange rate systems can be vulnerable to external economic shocks. When a country's economic conditions change significantly, it may struggle to maintain the fixed rate.
• Imbalance in Trade : Fixed exchange rates can lead to trade imbalances if the currency's value doesn't adjust to changes in the country's economic conditions. This can result in persistent trade deficits or surpluses.

What Is Flexible Exchange Rate System?

Merit of Flexible Exchange Rate System

• Automatic Adjustment : Flexible exchange rates allow currencies to adjust automatically to market forces, such as changes in supply and demand. This helps to maintain balance in international trade.
• Automatic Adjustment in BOP : One of the major advantages of a flexible exchange rate system is that it automatically corrects any disequilibrium in the Balance of Payments (BOP) through changes in the exchange rate. In the case of a BOP deficit, there will be an excess supply of the domestic currency, leading to a decrease in the exchange rate due to market forces of demand and supply. This depreciation makes exports cheaper (increasing exports) and imports more expensive (reducing imports), ultimately eliminating the BOP deficit. Conversely, in the case of a BOP surplus, there will be an excess demand for the domestic currency, causing the exchange rate to rise. This appreciation makes exports more expensive (reducing exports) and imports cheaper (increasing imports), restoring BOP equilibrium.
• Minimum Buffer of Foreign Exchange Reserves : Since the exchange rate in this system is not pegged, the central bank does not need to maintain a large foreign exchange reserve as a buffer against unforeseen developments in international trade.
• Monetary Policy Autonomy : Countries with flexible exchange rates have greater freedom in conducting their monetary policies. Central banks can adjust interest rates and money supply to stabilise their economies.
• Reduced Speculative Attacks : Flexible exchange rates are less prone to speculative attacks than fixed exchange rate systems. Market participants do not need to worry about central banks defending a particular exchange rate.
• Shock Absorption : Flexible exchange rates can absorb external economic shocks more effectively. When a country faces an economic downturn, its currency can depreciate, boosting exports and economic recovery.

Demerits of Flexible Exchange Rate System

• Exchange Rate Volatility : Flexible exchange rates can be highly volatile, creating uncertainty for businesses engaged in international trade and leading to unpredictable costs and revenues.
• Inflationary Pressures : Sharp depreciations in the exchange rate can lead to imported inflation as the cost of imports rises. This can be challenging for central banks trying to maintain price stability.
• Hindered Trade and Investment : Exchange rate volatility can discourage foreign direct investment and international trade, as businesses may be reluctant to engage in transactions due to uncertain future exchange rates.
• Hampers Investment : An unregulated flexible exchange rate can lead to erratic fluctuations, discouraging foreign investment. The uncertainty of exchange rates affects foreign investment deals' profit and loss outcomes, increasing the risk of capital outflows from the country.
• Adverse Effect on Economic Structure : A flexible exchange rate system can negatively impact a country's economy. The fluctuating exchange rates cause changes in the prices of exported and imported goods, leading to economic instability.
• Coordination Issues : In a world of floating exchange rates, coordination between countries can become more challenging, potentially leading to currency wars and competitive devaluations.

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