Question

Discuss the conditions under which fixed exchange may prove superior to flexible exchange rate. Be sure to discuss the set of operations (and their difficulties) necessary to maintain a fixed exchange rate. 50 points

Answer 1

A fixed exchange rate is a rate that is maintained and controlled by the government.And a flexible exchange rate is one that is determined by the market force.Hence fixed exchange rate is controlled by an apex monetary authority and flexible exchange authority by market forces of supply and demand.Some of the reasons why fixed exchange rate is considered superior to flexible exchange rate is as follows:

Providing greater certainty for importers and exporters, therefore encouraging more international trade and investment.The necessary condition for an orderly and steady growth of trade demands stability in exchange rate. Any undue fluctuations in exchange rate cause problems to the plans and programmes of both exporters and imports.

Helping the government maintain low inflation, which can have positive long-term effects such as keeping down interest rates.

As exchange rate re­mains unchanged for a fairly long period of time, people expect that such rate would not change in the immediate future. This then eliminates speculation in the foreign exchange market.

In poor developing countries experiencing BOP difficulties , an unstable ecxhange rate will further aggreviate BOP crisis leading to depreciation of home currency.A fixed echange rate prevent this scenario.

Exchange rate stability may encourage foreigners to invest their funds in a country. If the exchange rate changes rather frequently, it will resist  them to invest in a country.

A central bank maintains a fixed exchange rate by buying or selling its currency. If the domestic currency appreciates then the central bank will intervene and and sell its reserves of domestic currency in order to reduce the value of the domestic currency by increasing its supply in the forex market. Similarly if the domestic currency depreciates then central Bank would buy domestic currency in the forex market to increase it value.But some of the problems associated include :

A fixed exchange rate can be expensive to maintain. A country must have enough foreign exchange reserves to manage its currency's value.  In a fixed exchange rate, it is difficult to respond to temporary shocks as it is lesss flexible .It is also said that it can lead to speculation attacks .