Question

Discuss the pros and cons of fixed exchange rate systems and flexible exchange rate systems.

Answer 1

A fixed exchange rate also known as pegged exchange rate is a currency exchange mechanism in which one currency's value is bound to another. When exchanging money or trading between countries, there is less fluctuation by pegging one currency to another. Therefore currencies with fixed exchange rates are more stable and less affected by market conditions than floating exchange-rate currencies.

The advantages of a fixed exchange rate include

Providing greater certainty for importers and exporters, thus encouraging more trade and investment internationally.
Helping the government keep inflation low, which can have positive long-term effects such as keeping interest rates down.

The disadvantages of a fixed exchange rate include

Preventing currency changes which become undervalued or overvalued.
Limiting the extent to which central banks are able to adjust economic growth interest rates;
Requiring a large pool of reserves if it comes under pressure to support the currency.

A flexible exchange-rate system is a monetary system which allows supply and demand to decide the exchange rate.

Advantage of Flexible Exchange Rates

Under a flexible system of exchange rates, a country is free to follow an independent strategy for proper conducting domestic economic matters. A country's monetary policy isn't constrained or influenced by other countries ' economic conditions.

A fluctuating system of exchange rates protects the domestic economy from the shocks generated by the disturbances in other countries. While it serves as a shock absorber and protects the domestic economy from foreign upsetting impacts.

Disadvantage of Flexible Exchange Rates

The elasticity of the international markets is too low for exchange rates, variations to be successful in bringing about automatic adjustments to the balance. When the elasticities for import and export are very low, the exchange market becomes unstable. Hence, weak currency depreciation would simply tend to further worsen the balance of payments deficit.

Flexible exchange rates generate conditions of volatility and uncertainty which, in effect, tend to reduce the international trade volume and foreign investment. Long-term foreign investment arc dramatically decreased due to higher risks involved.