Question

1a. What are the advantages and disadvantages of fixed exchange rates?

1b. What are advantages and disadvantages of flexible exchange rates?

Answer 1

a. Advantages:

The necessary condition for orderly and steady commercial growth demands exchange-rate stability. Any undue exchange-rate fluctuations cause problems for both exporters and imports' plans and programmes.
In other words, export-earner wages and importer production prices appear to become volatile when the exchange rate fluctuates. A fixed exchange-rate method can remove this uncertainty. Furthermore, if exchange rates are not permitted to differ, the risks associated with foreign trade and investment are generally minimized.

In poor developed countries one encounters permanent form of BOP difficulties. Under the circumstances, any regular exchange rate adjustments will continue to worsen the BOP crisis, such as constant depreciation of home currency in other countries ' currencies. To put it another way, unstable exchange rates result in currency depreciation. The stable exchange-rate will prevent this.

Stable exchange rate regime impedes government implementation of reckless macro-economic policies such as currency devaluation. Above all, deflationary policies can be followed under the fixed exchange rate structure to tide over the BOP deficit, even without bringing in any improvements in domestic policies.

Disadvantages:

The necessary condition for the effectiveness of a stable exchange rate is that holding, foreign exchange reserves are adequate. Poor developing countries have difficulty maintaining adequate foreign-exchange reserves. Speculators then expect devaluation of currency in advance if BOP needs correction. In addition, prior to 1970, fixed exchange rates existed because of the low volume of global trade and, subsequently, the low volume of foreign reserves.

When countries encounter large and persistent BOP deficits or 'fundamental disequi-librium,' they are down with foreign reserves. Countries then opt for currency deva-luation, and take certain internal steps to reduce their deficits. These harsh internal measures tend to bring economies into contract. But the consequences of those actions are rising prices and rising unemployment. This then cut down on economic development. Thus, fixed exchange rates in the final analysis go for currency depreciation resulting in lower economic growth and higher unemployment coupled with high inflation the two most undesirable and unpleasant macro-economic variables that none likes.

2. Advantages:

Any balance of payments imbalance would be corrected automatically by a change in the exchange rate. For example , if a country then suffers from a balance of payments deficit, other things being equal, the currency of the country would have to depreciate. This would make exports to the country cheaper, thereby increasing demand, while at the same time making imports expensive and falling demand. Consequently the balance of payments equilibrium will be restored. On the opposite, by adjusting the exchange rate a balance of payments surplus will be immediately removed.

Crisis frequently characterized the periods of fixed exchange rates, as too much pressure was put on the central bank to devalue or revalue the currency of the country. But the central bank that devalued a currency by giving out too much of it would either end it or run out of it soon.

Disadvantages:

The very fact that currencies change their value from day to day introduces a considerable element of uncertainty into commerce. A seller can not be quite sure of how much money he will earn when selling products outside the country. Companies buying currency ahead in forward exchange contracts may reduce some of that uncertainty.

Daily fluctuations in exchange rates may encourage country-to - country speculative 'hot money' movements, causing more and mooring exchange rate fluctuations.