Question

Critically evaluate the flexible exchange rate system advantages and disadvantages. Is a fixed gold like standard exchange rate system for the globe warranted at this time? Explain.

Answer 1

Flexible Exchange Rate:

Advantages:

• Protection from external shocks - if the exchange rate is free to float, then it can change in response to external shocks like oil price rises. This should reduce the negative impact of any external shocks. Under this system, the threat of ‘importing inflation’ from outside the country is minimum.
• Lack of policy constraints - the government are free with a floating exchange rate system to pursue the policies they feel are appropriate for the domestic economy without worrying about them conflicting with their external policy. Since exchange rate is not pegged under the floa­ting arrangement of exchange rate, the central bank of a country need not hold adequate foreign exchange reserves as a buffer against unforeseen developments in international trade.
• Correction of balance of payments deficits - a floating exchange rate can depreciate to compensate for a balance of payments deficit. This will help restore the competitiveness of exports. If a BOP deficit arises, there would be an excess supply of home currency leading to a fall in exchange rate simply by the market forces of demand and supply. This causes export goods cheaper and import goods dearer.

Disadvantages:

• Instability - floating exchange rates can be prone to large fluctuations in value and this can cause uncertainty for firms. Investment and trade may be adversely affected. The uncertainty involved in this kind of exchange rate may cause trading community to lose some confidence in the system.
• No constraints on domestic policy - governments may be free to pursue inappropriate domestic policies (e.g. excessively expansionary policies) as the exchange rate will not act as a constraint.
• Speculation - the existence of speculation can lead to exchange rate changes that are unrelated to the underlying pattern of trade. This will also cause instability and uncertainty for firms and consumers
• Inflationary in Character: Flexible exchange rate is inflationary. As soon as the exchange rate falls, automatically, consequent upon the BOP deficit, import goods become expensive. High cost of imported goods then fuels inflationary tendencies. As depreciation of a currency makes import costlier, the domestic economy faces both demand-pull and cost-push inflationary pressures.

The fixed gold standard menas a fixed monetary regime under which the government's currency is fixed against Gold.

Advantages and Disadvantages of the Gold Standard

There are many advantages to using the gold standard, including price stability. This is a long-term advantage which makes it harder for governments to inflate prices by expanding the money supply. Inflation is rare and hyperinflation doesn't happen because the money supply can only grow if the supply of gold reserves increases. Similarly, the gold standard can provide fixed international rates between countries that participate and can also reduce the uncertainty in international trade.

But it may cause an imbalance between countries that participate in the gold standard. Gold-producing nations may be at an advantage over those that don't produce the precious metal, thereby increasing their own reserves. The gold standard may also, according to some economists, prevent the mitigation of economic recessions because it hinders the ability of a government to increase its money supply — a tool many central banks have to help boost economic growth.