Question

what are the disadvantages of flexible exchange rates?

Answer 1

Disadvantages of flexible exhange rate:

(a) Adverse effect of Debt: In this exchange rate system debt burden will increase because at the time of taking the debt exchange rate may be different and while at the redemption time due to change in exchange rate we have to pay more. We can understand by this example, suppose if India takes loan of 100$ from U.S.A at 50₹ =1$ exchange rate. But Indian currency depreciate and now exchange rate is 100₹ =1$. Thus India has to pay more to the U.S.A. So poor countries will suffer more form this exchange rate system.

(b) Unstable circumstances: This exchange rate system create conditions of volatility and uncertanity and this will reduce the size of international trade and discourages the foreign investment. Due to flexibilty in the exchange rate it makes difficult for the investors to predict losses and profit. So long term foreign investment also reduce drastically.

(c) Negative effect on the economic system: The flexible exchange rate mechanism has a significant effect on the economic system. This exchange rates cause changes in the prices of imported and exported products,which, in effect, unstable the economy of the country.

(d) Needless capital movement: The fluctuating exchange rate regime contributes to excessive international capital movements. By promoting financial activities, such a program induces large-scale capital outflows and inflows, causing significant disruption to the economy of the country.

(e) Price rise effect: This exchange rate system involves greater possibility of inflationary effect of exchange depreciation on domestic price level of a country. This rise in prices leads to further depreciation of the external value of the currency and this will create mote pressure on the economy.

(f) Risk and Speculation: Flexible exchange rate promotes widespread uncertainty, because foreign exchange values are not defined in advance. It's because of skepticism that hot capital flows are destructive. When the exchange rate begins to fall, speculators expect that it will continue to decline further and that the prospect of a transfer of capital to another country will brighten up. This will lead to a further fall in the exchange rate. Therefore, the greater the betting against the currency, the deeper the economic crisis.