Merits and Demerits of Fixed Exchange Rate System

The fixed exchange rate system has been a topic of significant debate among economists and policymakers worldwide. This monetary system, where a country's currency is pegged to another major currency or a basket of currencies, offers advantages and disadvantages. Proponents argue that it provides stability and predictability, crucial for fostering international trade and investment. However, critics highlight its potential drawbacks, such as limited monetary policy flexibility and vulnerability to speculative attacks. This article examines the merits and demerits of the fixed exchange rate system, offering a balanced perspective on its impact on economies and global markets.

What is a Fixed Exchange Rate System

Merits Fixed Exchange Rate System

• Elimination of Uncertainty and Risk : Stability in the exchange rate is crucial for ensuring orderly and consistent growth in trade. Changes in the exchange rate can disrupt plans for importers and exporters, leading to uncertain income and increased costs for importers. A fixed exchange rate system eliminates this uncertainty.
• Discouragement of Speculation : Under a fixed exchange rate system, where the exchange rate remains stable over a prolonged period, speculation in the foreign exchange market is discouraged. This stability also deters capital flight, as fluctuations in the exchange rate can incentivise speculative activities. Due to the fixed exchange rate, traders can confidently conduct international transactions.
• Attraction of Foreign Investment : A country with a fixed exchange rate system may attract foreign investment, contributing to high economic growth through multiplier effects.
• Anti-inflationary Nature : The fixed exchange rate system is inherently anti-inflationary. If the exchange rate fell, imported goods would become more expensive, potentially leading to inflation. A fixed exchange rate system prevents such situations.
• Prevention of Currency Depreciation : Developing countries often face persistent balance of payment difficulties. In such situations, changes in the exchange rate can exacerbate the crisis, leading to continuous depreciation of the domestic currency against other currencies. A fixed exchange rate system prevents this.
• Promotion of Responsible Macroeconomic Policies : A stable fixed exchange rate system prevents governments from adopting irresponsible macroeconomic policies like devaluation. It also allows countries to pursue deflationary policies to address balance of payment deficits without resorting to domestic policy changes.

Demirtis Fixed Exchange Rate System

• Limited Monetary Policy Autonomy : Countries that adopt fixed exchange rates face constraints on their ability to implement independent monetary policies, which can restrict their capacity to respond effectively to economic shocks and fluctuations. This limitation arises because changes in interest rates or money supply intended to address domestic economic conditions may conflict with the need to maintain the fixed exchange rate.
• Speculative Vulnerability : Fixed exchange rate regimes expose countries to speculative attacks from investors who bet against the sustainability of the currency's peg. Speculation can undermine confidence in the currency and lead to capital outflows, forcing the central bank to deplete its reserves or raise interest rates to defend the fixed rate.
• Susceptibility to External Shocks : The fixed exchange rate system can leave countries vulnerable to external economic shocks, such as changes in global interest rates or commodity prices. These shocks may necessitate costly interventions by the central bank to maintain the fixed rate, potentially depleting foreign exchange reserves or increasing public debt.
• Trade Imbalance : Fixed exchange rates may contribute to trade imbalances if the currency's value does not adjust to reflect changes in the country's economic conditions. When the fixed rate does not align with the country's competitiveness or trade flows, persistent deficits or surpluses can occur, potentially leading to long-term economic distortions.
• Potential Currency Crises : The inability to sustain the fixed exchange rate can trigger currency crises and economic instability. If market pressures force the central bank to abandon the fixed rate, it can lead to rapid currency depreciation, capital flight, and inflationary pressures, threatening overall economic stability.
• Loss of Policy Flexibility : The fixed exchange rate system limits the flexibility of monetary policy to respond to domestic economic conditions. Central banks may find adjusting interest rates or money supply challenging to address inflation, unemployment, or other economic goals independently of maintaining the fixed rate.
• Long-Term Economic Distortions : Fixed exchange rates may perpetuate economic inefficiencies and resource misallocation by preventing the currency from adjusting to market forces. This rigidity can hinder the country's ability to achieve sustainable economic growth and development over the long term.
• Dependency on Foreign Exchange Reserves : Central banks often need substantial foreign exchange reserves to maintain the fixed rate. This dependency exposes the country to risks associated with fluctuations in exchange rates, changes in global financial conditions, and potential depletion of reserves during periods of economic stress.
• Methods of Fixed Exchange Rate in Earlier Times

• Countries were required to peg their currencies to the US Dollar ($).
• The US Dollar was assigned a fixed gold value.
• The value of other currencies, such as the £ (UK Pound), was pegged to the US Dollar, which implied their value in gold.
• Gold remained the ultimate unit of parity.
• The International Monetary Fund (IMF) was the central institution overseeing this system.
• The Bretton Woods System was eventually abandoned and replaced by the Flexible Exchange Rate System in 1971.

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