Question

Which of the following statements are correct regarding the preferability of a system of flexible exchange rates compared to a system of fixed exchange rates?

(a) Flexible exchange rates eliminate the exchange rate risk. (b) Flexible exchange rates help maintaining monetary discipline. (c) Flexible exchange rates require the country to hold very large international reserves. (d) Flexible exchange rates allows the country to use monetary policy for stabilization purpose.

Answer 1

Option (A) is wrong because flexible exhange rate is so volatile it does not eliminate the exchange rate risk. Rather, flexible exhange rate is driven by market forces it comes under high risk.

Option (B) is wrong flexible exhange rate do not help in maintaining monetary discipline. Rather short term monetary policies (like, changing repo rates) of central banks of the countries helps them to appreciate or depreciate their flexible exchange rate.

Option (C) is wrong flexible exchange rate is totally driven by market forces. Government intervention and government policies required in valuation of fixed exchange rate not flexible exchange rate. So, fixed exchange rate requires a contry to hold large forex reserves. Forex reserves helps them to maintain their currency value at fixed rate.

Option (D) is correct.

Because monetary policies are used by central banks to influence floating or flexible exchange rates not the fixed exchange rate. Monetary policies are ineffective in case of fixed exchange rates. Central banks of the countries makes short term and long term monetary policies to influence the demand and supply of domestic currency in the market. For example, selling government securities in the open market would increase the supply of domestic currency in the market.