Fixed Exchange Rate and Flexible Exchange Rate, including arguments in favour and against the flexible exchange rate system.
20/June/2025 01:23
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Here is a short but detailed note on Fixed Exchange Rate and Flexible Exchange Rate, including arguments in favour and against the flexible exchange rate system.
1. Fixed Exchange Rate System
Definition:
A fixed exchange rate is a system in which the value of a country's currency is tied or pegged to another major currency (like the US Dollar) or to a basket of currencies or gold.
Features:
The central bank intervenes in the foreign exchange market to maintain the fixed rate.
Exchange rate remains stable over time.
Government-controlled exchange rate mechanism.
Examples:
Bretton Woods System (post-WWII period)
Countries like Saudi Arabia peg their currency to the US Dollar.
Advantages:
Stability in trade and investment.
Control over inflation through a disciplined monetary policy.
Promotes investor confidence.
Disadvantages:
Central bank needs large foreign exchange reserves.
Limits monetary policy independence.
Can lead to black market activities if rates are unrealistic.
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2. Flexible (Floating) Exchange Rate System
Definition:
A flexible exchange rate is a system where the value of a currency is determined by market forces—i.e., demand and supply of foreign exchange—without direct government or central bank control.
Features:
The exchange rate fluctuates freely according to international market conditions.
Central bank may intervene occasionally to reduce extreme volatility (called managed float).
Reflects economic fundamentals like inflation, interest rates, and trade balance.
Examples:
Most major economies like the USA, UK, Eurozone, and India (managed float).
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Arguments in Favour of Flexible Exchange Rate
1. Automatic Adjustment:
Exchange rate adjusts automatically to correct balance of payments deficits or surpluses.
2. Independent Monetary Policy:
Governments can focus on domestic goals like inflation control or economic growth without worrying about exchange rate stability.
3. No Need for Huge Reserves:
Reduces the pressure on central banks to maintain large forex reserves.
4. Encourages Export Competitiveness:
A depreciated currency can make exports more competitive in international markets.
5. Reflects True Economic Conditions:
Exchange rate changes reflect real economic signals, guiding international investors and policymakers.
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Arguments Against Flexible Exchange Rate
1. Exchange Rate Volatility:
Frequent fluctuations can discourage international trade and investment.
2. Speculative Attacks:
Currencies can become targets for speculators, leading to artificial depreciation or appreciation.
3. Imported Inflation:
Depreciation of currency can increase the cost of imports, leading to inflation in the domestic economy.
4. Uncertainty in Planning:
Businesses and governments may find it difficult to make long-term trade and investment decisions due to unpredictable rates.
5. Lack of Discipline:
May lead to irresponsible fiscal and monetary policies, as there's no external check like in fixed systems.
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Conclusion
Both exchange rate systems have their merits and limitations.
A fixed exchange rate offers stability but limits economic freedom.
A flexible exchange rate promotes market efficiency and policy independence, but may cause volatility and uncertainty.
For developing economies like India, a managed float system (a mix of both) is often seen as the most practical and balanced approach.
