Question

Describe the pros and cons of a fixed exchange rate system.

Answer 1

A fixed exchange rate is a regime applied by a country whereby the government or central bank ties the official exchange rate to another country's currency or to the price of gold. The purpose of a fixed exchange rate system is to maintain a country's currency value within a narrow band.
Fixed rates provide greater certainty for exporters and importers. Fixed rates also helps the government maintain low inflation, which, in the long run, keeps interest rates down and stimulates trade and investment. Most major industrialized nations have had floating exchange rate systems since the early 1970s while developing economies continue to have fixed rate systems.

Advantages:

(i) Elimination of Uncertainty and Risk:

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.

In other words, incomes of export-earners and the cost of imports of the importers tend to become uncertain if the exchange rate fluctuates. This uncertainty can be removed by a fixed exchange rate method. Further, the risks associated with international trade and investment get minimised largely if exchange rates are not allowed to vary.

(ii) Speculation Deterred:

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.

Further, as stability in the exchange rate over longish period eliminates the threat of speculation, it discourages the flight of capital. In a world of free fluctuating exchange rate, the danger of the flight of capital is rather high as this kind of exchange rate induces people to speculate. As exchange rates remain fixed, traders have a sense of confidence that international payments can be made safely without the danger of losses.

(iii) Prevention of Depreciation of Currency:

In poor developing countries, one experiences BOP difficulties of a permanent type. Under the circums­tances, any frequent changes in exchange rate will tend to aggravate the BOP crisis, like continuous depreciation of home currency in terms of curren­cies of other countries. In other words, unstable exchange rates result in depreciation of currencies. This can be prevented by the stable exchange rate.

(iv) Adoption of Responsible Macroeconomic Policies:

Stable exchange rate system prevents government from adopting irresponsible macro- economic policies like devaluation of currencies. Above all, under the fixed exchange rate system, deflationary policies can even be pursued to tide over the BOP deficit, even without bringing any change in domestic policies.

(v) Attraction of Foreign Investment:

Exchange rate stability may encourage foreigners to perk their investible funds in a country. If the exchange rate changes rather frequently, it will deter them to invest in a country. Of course, such foreign investment having multiplier effect leads to higher economic growth.

(vi) Anti-inflationary:

Fixed exchange rate system is anti-inflationary in character. If exchange rate is allowed to decline, import goods tend to become dearer. High cost import goods then fuels inflation. Such a situation can be prevented by making the exchange rate fixed.

Disadvantages:

(i) Speculation Encouraged:

In fact, uncertainty and, hence, speculative activities, tend to get a boost even under the fixed exchange rate system. Under a fixed rate system, if a country faces huge BOP deficit then the possibility of speculation gets brightened. If the speculators can guess that such BOP deficit will persist in the days ahead and the authority may go for a cut in foreign exchange rate then these people will be more enthu­siastic to sell domestic currencies in the foreign exchange market.

If such sale of home currencies continues for a longer period, the central bank will then be forced to reduce exchange rate, instead of keeping it at the old fixed rate. Under the circums­tance, speculators go on buying home currencies where exchange rates have been reduced. This will make these people to earn profit. The Bretton Woods System of the IMF collapsed in 1971 because of such speculation made with the US dollars.

(ii) Adequacy of Foreign Exchange Reserves:

For the effectiveness of a stable exchange rate, the necessary condition is the adequacy of holding, foreign exchange reserves. Poor developing countries find it difficult to maintain an adequate volume of foreign exchange reserves. Speculators then anticipate currency devaluation in advances if BOP needs to be corrected. Before 1970, fixed exchange rate, in fact, prevailed because of low volume of global trade and, hence, low volume of foreign exchange reserves.

(iii) Internal Objectives of Growth and Full Employ­ment Sacrificed:

When countries experience large and persistent deficits or ‘fundamental disequi­librium’ in BOP, they are down with the foreign exchange reserves. Countries then opt for deva­luation of their currencies and take some internal measures to reduce their deficits.

These harsh internal measures tend to contract economies. But the fallouts of these measures are rising prices and rising unemployment. These then reduce economic growth. Thus, fixed exchange rate—in the ultimate analysis—go for currency depreciation that results in lower economic growth and higher unemployment coupled with high inflation—the two most undesirable and unpleasant macro- economic variables not liked by anyone.

(iv) International Competitive Environment By­passed:

The continuous changes in international competitive environment do not get reflected under the fixed exchange rate system. Thus, to make the home product more competitive in the foreign market, what is required is the change in domestic economic policies so that the country’s export products get larger foothold in the foreign market. In other words, the fixed exchange rate system fails to gloss over the international competitive environment.

This kind of exchange rate developed after the World War II. The International Monetary Fund set up by the Bretton Woods Agreement of 1944 came into operation in March 1947. The period 1947-1971 came to be known as ‘fixed but adjus­table exchange rate system’ or ‘par value system’ or the ‘pegged exchange rate system’ or the ‘Bretton Woods System’.