Merits and Demerits of Flexible and Fixed Exchange Rate Systems | Testbook.com (2024)

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.

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.

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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

The merits have been stated below.

• Stability and Predictability: Fixed exchange rates offer stability and predictability for businesses engaged in international trade. Knowing that exchange rates won't fluctuate significantly provides a favorable environment for planning.
• Inflation Control: Fixed exchange rates can help control inflation, as they limit the central bank's ability to print excessive money to finance government deficits.
• Exchange Rate Risk Mitigation: Businesses and investors can hedge against exchange rate risk more effectively in a fixed exchange rate system because 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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Demerits

The demerits have been stated below.

• 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. The central bank may deplete its foreign exchange reserves in defense.
• 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.

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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

The merits have been stated below.

• Price Stability: Fixed exchange rates provide price stability, making it easier for businesses to plan and budget for international trade.
• Reduced Currency Risk: Businesses and investors can hedge against currency risk more effectively in a fixed exchange rate system.
• Promotes International Trade: A fixed exchange rate system can promote international trade by reducing uncertainty about exchange rate movements.
• Inflation Control: It can help control inflation, as the central bank's ability to print money to finance government deficits is limited.

Stability for Investments: Fixed rates provide stability for foreign direct investments, attracting capital from abroad.

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Demerits

The demerits have been stated below.

• Limited Monetary Policy Autonomy: Countries with fixed rates have limited control over their domestic monetary policies, which can hinder their ability to respond to economic shocks.
• Speculative Vulnerability: Fixed rates can make a country vulnerable to speculative attacks by investors betting against the currency's peg.
• External Shocks: The system can be vulnerable to external economic shocks, which may require costly interventions to maintain the fixed rate.
• Trade Imbalance: Fixed exchange rates may lead to trade imbalances if the currency's value doesn't adjust to changes in the country's economic conditions, resulting in persistent deficits or surpluses.
• Potential Currency Crises: If the central bank cannot maintain the fixed rate, it can lead to currency crises and economic instability.

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Conclusion

The choice between flexible and fixed exchange rate systems is a significant decision for any country, and each system comes with its own set of merits and demerits. Flexible exchange rates offer automatic adjustments and monetary policy independence but can result in exchange rate volatility. Fixed exchange rates provide stability and predictability but limit policy autonomy and can be vulnerable to speculative attacks. The decision depends on a country's specific economic goals, risk tolerance, and policy priorities. Some countries adopt a managed exchange rate system, combining elements of both, to strike a balance between stability and flexibility in their exchange rate policies.

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.

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