Question

Assess the advantages and disadvantages of adoption of the Fixed versus Flexible exchange rate system. Choose and explain the exchange rate regimes you consider to be best suited for the small developing countries.

Answer 1

Advantages of Fixed Exchange rate
1. The importers and exporters are assured for exchange rate and can plan according as they are protected for exchange rate fluctuations.
2. Foreign Investors can invest without thought of foreign exchange risk.
3. Other countries with floating exchange rate might frame polices with countries with fixed interest rate ti make there domestic companies more competitive.

Disadvantages of fixed Exchange Rate :
1. Speculation can be high when the market senses that the government might take steps to balance the market forces by increasing or decreasing rates.
2. It reduces flexibility in the economy
3. There might be a current account deficit because of this.


Advantages of floating exchange rate :
1. No need of government intervention as the market forces stabilizes the exchange rates.
2. It is Market friendly as it encourages investors and foreign trade.
3. It helps in counterbalancing inflation. When inflation is low exchange rate is high and when inflation is high exchange rates become low.

Disadvantages of floating exchange rates:
1.Due to uncertainty FDI ( Foreign Direct investment ) might be low as these investments are for longer term .
2. Day to day speculations can occur and fluctuations do cause arbitrage opportunity.
3. It might influence government to push for expansionary monetary policy which might disturb the economy as they are not under pressure to manage exchange rate.

Pegged Currency is best suited for small developing countries. Pegged currency means exchange rate is fixed against a strong currency. Many countries have pegged against US dollars. This helps them in pursuing an independent fiscal policy without having to control the monetary policies. The domestic currency becomes stable as it is pegged to a strong currency.
However the inflation and economic shock of the stronger currency is passed on the pegged currency.