Merits and Demerits of Flexible and Fixed Exchange Rate Systems

Exchange rate systems are mechanisms used by countries to determine the value of their currency in relation to other currencies. The two primary exchange rate systems are flexible (floating) and fixed (pegged) exchange rate systems, each with its own set of advantages and disadvantages. These systems play a crucial role in shaping a nation's economic policies and international trade dynamics. The merits of fixed exchange rate include stability in trade, while the demerits of fixed exchange rate can involve difficulties in adjusting to economic changes.

Merits and demerits of flexible and fixed exchange rate systems and knowing about the exchange rate systems in general is a very important topic to be understood for the commerce related examinations such as UGC-NET Commerce Examination.

In this article, the readers will be able to find out about the merits and demerits of flexible and fixed exchange rate systems along with some other related topics.

Merits and Demerits of Flexible and Fixed Exchange Rate Systems

Exchange rates are what nations use to determine how much their currency is worth in relation to other nations.The merits and demerits of fixed exchange rate rely on the stability it offers against the inconvenience it poses in adapting to economic changes.The advantages and disadvantages of flexible exchange rate accentuate the economic adjustment advantages, but also currency fluctuation risks. There are two forms: fixed exchange rates and flexible exchange rates. Both have advantages and disadvantages.

Fixed Exchange Rate System

In a fixed exchange rate system, a country pegs its currency to another currency or a basket of currencies at a specific rate. The central bank intervenes to maintain this fixed rate by buying or selling its currency in the foreign exchange market.

Merits of Fixed Exchange Rate

A fixed exchange rate system simplifies international trade since individuals are aware of the exact value of their money in relation to other currencies. It also stabilizes inflation and prices, making the economy more predictable.

Stability in Trade

With a fixed exchange rate, countries and businesses can plan more easily since they understand that the money value will not fluctuate rapidly. This implies that if a business in a country wishes to purchase goods from another country, they do not have to be concerned about the money value changing during the negotiation. It makes it easier to avoid surprises in the import and export cost. Nations can also exchange more freely, with the assurance that prices will be stable. This facilitates international business and makes it more predictable.

Inflation Control

With a fixed exchange rate, the government can regulate the value of their currency, which prevents inflation. Inflation is when prices for goods such as food and clothing increase, making life costlier. A fixed exchange rate prevents the value of money from falling too rapidly, and that causes inflation. This makes individuals and businesses understand what they can expect regarding the price of goods. When inflation is managed, the economy is more stable and individuals can budget more effectively.

Encourages Foreign Investment

When foreign investors notice that a currency's value is fixed, they are willing to invest because they know that their money won't depreciate fast while waiting to make an investment. Investment translates to increased business growth, and nations will be able to develop. Fixed exchange rate ensures that investors are confident and willing to invest in the nation. This is good for the economy because it creates jobs and encourages growth.

Easier for Travelers

When traveling to another country, a fixed exchange rate makes it easier for people to know how much money they will get in exchange. If the rate is always the same, tourists don’t need to worry about how the value of their currency might change while they are abroad. It simplifies travel and makes it cheaper as the price of goods and services does not fluctuate unnecessarily. A traveler knows how much they can budget for, and the exchange rate will remain constant. It eliminates confusion and allows individuals to enjoy their travel experience better.

Stops Currency Wars

In a fixed system of exchange rates, nations promise to keep their currency values constant relative to each other. This prevents "currency wars," when nations try to devalue their currency to make their exports cheaper. If nations keep their currencies stable, this encourages friendly trade relations and does not lead to conflicts. This collaboration results in a balanced global economy, with no single nation constantly trying to get ahead by devaluing its money. This decreases tensions between nations and promotes fair trade.

Demerits of Fixed Exchange Rate

Although a fixed exchange rate system provides stability, it may be detrimental to a country's economy. It might restrict a nation's response to economic changes and create difficulties in times of need.

Requires Large Reserves of Foreign Currency

In a fixed exchange rate system, the nation needs to keep large reserves of foreign money in order to keep its own currency's value. It can be quite costly for the government since they have to purchase and keep foreign nations' money. If the nation lacks foreign money, it might not be able to keep its exchange rate stable. This may cause difficulties in foreign trade and damage the economy. Maintaining huge reserves may be cumbersome and expensive for less resourceful smaller nations.

Limited Flexibility in Times of Crisis

When a nation is experiencing economic issues, such as a recession or inflation, a fixed exchange rate may make it more difficult to correct the situation. Typically, a nation would be able to change the value of its currency to assist in fixing economic issues, but with a fixed rate, that is not possible. This implies that if there is an issue with the economy, the government may not have sufficient mechanisms to address it promptly. For instance, if there is excessive inflation, the nation cannot just devalue its currency to assist in fixing the issue. This makes the economy less strong and more difficult to repair in times of difficulty.

Risk of Speculation

With a fixed exchange rate, individuals may attempt to predict when the government will shift the value of its currency. This is known as speculation, and it may be dangerous to the economy. If a large number of individuals attempt to exchange their money at the correct time, it can create issues with the value of the currency. This speculation can damage the financial system of the country, and it will become difficult to sustain the fixed exchange rate. It may even result in abrupt and significant shifts in the economy that are difficult to manage.

Can Lead to Trade Imbalances

If a nation's money is fixed at a level that is too high or too low, it will lead to trade imbalances. This implies that the nation may import too many products since its money is undervalued or export too little because its money is overvalued. For instance, if a nation's money is fixed too high, foreigners will find it costly to purchase its products. This may result in less sale and damage businesses in the nation. Imbalances in trade can also create issues with other nations, and trade disputes over policies.

Can Result in Loss of Confidence

If one nation fixes the value of another currency for a long period of time, individuals may lose faith in it. Unless the fixed rate is possible and aligns with the actual value of the country's economy, individuals will lose confidence in the money. This can result in individuals refusing to use the money for trade or savings, which can weaken the economy. The increase in prices and businesses experiencing difficulties can result from a loss of confidence in the currency. This can cause damage to individuals' savings and increase the difficulty of recovering from financial issues for the nation.

After studying these notes aspirants will be able to answer the question write the merits and demerits of flexible and fixed exchange rate system easily.

Flexible Exchange Rate System

In a flexible exchange rate system, exchange rates are determined by market forces such as supply and demand. Currency values can fluctuate freely, responding to economic conditions and expectations without government or central bank intervention.

Merits of Flexible Exchange Rate

Flexible exchange rate system enables nations to adjust their currency value depending on forces of the market, such as supply and demand. It enables nations to react rapidly to the changing forces of the world economy.

Automatic Adjustment

Under a flexible exchange rate system, a nation's currency can appreciate or depreciate naturally in relation to what individuals are prepared to pay for it. If an economy is strong, there will be more individuals who would like to purchase its currency, thus strengthening the currency. If an economy is weak, the currency may decrease in value. This tends to automatically equalize trade since a depreciated currency can price a nation's exports low enough to easily sell them. It's like a mechanism for the economy to self-correct without relying too much on the government. 

Shield Against External Shocks

A floating exchange rate will protect countries from sudden changes in the global market, such as a sudden price drop in oil or other commodities. If the value of something valuable goes down, the country's currency can adjust to reflect this drop. For example, when oil prices go down, the currency of an oil-dependent country can drop, causing others to pay less for its goods. This reduces the negative effects of such shocks. The economy can keep on working more normally since the exchange rate can adjust quickly to the new conditions.

Reduced Requirement for Government Interventions

Flexible exchange rate countries do not need to spend so much money attempting to regulate the value of their currency. Under a fixed exchange rate regime, the government needs to work hard in order to stabilize the value of its currency by buying and selling it in bulk. Under flexible exchange rates, the market determines the value depending on demand, and as such, the government does not need to do so much. This saves governments a great deal of money and effort. 

Promotes Trade and Investment

Flexible exchange rates can make it simpler for nations to trade and invest in one another. When exchange rates fluctuate naturally, it facilitates nations to find reasonable prices for their goods and services. This makes companies purchase and sell products across borders, and this enables everyone to make money. For instance, if the currency of a country gets cheaper, foreign people may need to purchase more of its products. This means more trade takes place and the relationships between countries get stronger.

Assists in Economic Stability

Flexible exchange rates make the economy remain stable in the long term since the value of the currency changes when it is necessary. If the nation is experiencing inflation or it has a lot of debt, the currency will tend to depreciate, which can actually slow inflation by increasing the cost of imports. Conversely, if the nation is prospering, the value of the currency can appreciate, which can assist in keeping inflation in balance. It provides a type of equilibrium that maintains the health of economies. It’s like the currency can breathe and move around to keep the economy in a good place.

Demerits of Flexible Exchange Rate

Though the flexible exchange rate system has advantages, it also possesses some disadvantages. These issues are able to influence the stability of a nation's economy and the way businesses conduct trade with other nations.

Currency Fluctuations

One of the largest issues with a flexible exchange rate system is that a country's currency can fluctuate significantly. This can make it more difficult for companies to know how expensive things will be in the future. For instance, if a currency becomes much less valuable, it can increase the price of imports considerably. This can be dangerous for firms that rely on purchasing things from abroad. It can also make it more difficult for families to save or make plans for the future.

Risk of Speculation

Another negative aspect is that individuals might attempt to profit by speculating on the way that currency values will shift. Speculators purchase and sell currencies frequently in an attempt to make a profit, which can lead the value of a currency to fluctuate more and more. This can lead to confusion within the market and make it more difficult for firms to determine prices. When currencies are volatile, individuals might be reluctant to invest or trade with other nations. This can decelerate the economy since it makes things uncertain.

Effect on Imports and Exports

Flexible exchange rates can make it more difficult for nations to trade with one another, particularly if their currencies are fluctuating greatly. When a nation's currency is lower in value, its exports become less expensive, which is beneficial for selling products. But if the currency unexpectedly strengthens, the same products can cost others more to purchase. This can be detrimental to companies that depend on selling their goods overseas. At times, the fluctuating value of a currency can complicate it for nations to have equitable trade relations.

Challenge in Planning Economically

Flexible exchange rate countries can struggle with long-term economic planning. Because the value of money can rise or fall rapidly, governments may find it difficult to estimate how much things will cost in the future. This may make it more difficult to produce budgets for schools, hospitals, or public services. Companies also have a problem planning because they do not know what is happening in the currency market. If there is no stability in the currency, it becomes more difficult for everyone to make good financial choices.

Higher Inflation

In a system of flexible exchange rates, the price of a nation's currency can fall, which causes inflation. Inflation is when prices of common items, such as food or clothing, rise, making them more difficult for people to buy. If a nation's currency falls in value rapidly, the price of importing items can increase significantly. 

Conclusion

The decision between a flexible and a fixed exchange rate system is a major one for any nation, and both systems have their respective advantages and disadvantages. Flexible exchange rates provide automatic adjustment and policy independence in monetary policy but lead to exchange rate volatility. Fixed exchange rates assure stability and certainty but restrict policy autonomy and are susceptible to speculation attacks. The choice varies with a nation's particular economic objectives, attitude towards risk, and policy objectives. A managed exchange rate regime, which unites the advantages of both in a compromise solution, is applied by some countries to balance the stability and the flexibility of the exchange rate management.

Merits and Demerits of Flexible and Fixed Exchange Rate Systems is a vital topic as per several competitive exams. It would help if you learned other similar topics with the Testbook App.