Question

What are the arguments for and against flexible exchange rates?

Answer 1

Some of the advantages and arguments for flexible exchange rate are as follows -

1. Fairly Valued Currency - When the currency is allowed to fluctuate based on the fundamentals that impact the exchange rates, the currency tends towards fair valuation. As the problem of undervaluation and overvaluation is avoided, the friction between countries on currency manipulation can be avoided.

2. Automatic Stabilizers - Flexible exchange rates serve as automatic stabilizers in the economy. When other economies are in a slowdown and demand for exports declines, the output in the country also declines. This translates into a weaker currency, which is positive for exports. Similarly, when demand surges, the currency also strengthens. Therefore, by default, the currency movement helps in easing trade depending on economic outlook. This also promotes growth in international trade.

3. Central Bank Independence - When there is a flexible exchange rate system, the central bank has higher powers to pursue expansionary or contractionary monetary policy. Since monetary policy has an impact on inflation, countries under flexible exchange rate can have their own inflation rate targets. Just as an example, the United States central bank targets inflation around 2.0%.

However, there are some disadvantages of flexible exchange rate system. These are as follows -

1. Instability and Uncertain Scenario - When there are several economic, political and other news in the local or global economy, the flexible exchange rate system implies relatively volatile currency movement and this creates a uncertain scenario for trade, businesses and the monetary authorities. However, for big economies, exchange rates are relatively stable.

2. Excessive Use of Monetary Policy - A flexible exchange rate allows central banks independence and that can be counter-productive as well. Just as an example, ultra expansionary monetary policies translated into high inflation to hyper inflation in countries like Zimbabwe and Venezuela.