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What are the advantage and disadvantage of Flexible Exchange Rate system?

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What are the advantage and disadvantage of Flexible Exchange Rate system?
posted Jun 28, 2017 by Sherlyn Mishra

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Advantage of Flexible Exchange Rates

Flexible exchange rate system is claimed to have the following advantages:

1. Independent Monetary Policy:

Under flexible exchange rate system, a country is free to adopt an independent policy to conduct properly the domestic economic affairs. The monetary policy of a country is not limited or affected by the economic conditions of other countries.

2. Shock Absorber:

A fluctuating exchange rate system protects the domestic economy from the shocks produced by the disturbances generated in other countries. Thus, it acts as a shock absorber and saves the internal economy from the disturbing effects from abroad.

3. Promotes Economic Development:

The flexible exchange rate system promotes economic development and helps to achieve full employment in the country. The exchange rates can be changed in accordance with the requirements of the monetary policy of the country to achieve the planned national objectives.

4. Solutions to Balance of Payment Problems:

The system of flexible exchange rates automatically removes the disequilibrium in the balance of payments. When, there is deficit in the balance of payments, the external value of a country's currency falls. As a result, exports are encouraged, and imports are discouraged thereby, establishing equilibrium in the balance of payment.

5. Promotes International Trade:

The system of flexible exchange rates does not permit exchange control and promotes free trade. Restrictions on international trade are removed and there is free movement of capital and money between countries.

6. Increase in International Liquidity:

The system of flexible exchange rates eliminates the need for official foreign exchange reserves, if the individual governments do not employ stabilization funds to influence the rate. Thus, the problem of international liquidity is automatically solved. In fact, the present shortage of international liquidity is due to pegging the exchange rates and the intervention of the IMF authorities to prevent fluctuations in the rates beyond a narrow limit.

7. Market Forces at Work:

Under the flexible exchange rate system, the foreign exchange rates are determined by the market forces of demand and supply. Market is cleared off automatically through changes in exchange rates and the possibility of scarcity or surplus of any currency does not exist.

8. International Trade not Promoted by Fixed Rates:

The argument that fixed exchange rates promotes international trade is not supported by historical facts of inter-war or post-war period. On the other hand under the flexible exchange rate system, the trend of the rate of exchange is generally assessed through the forward market, and the traders are protected from financial losses arising from fluctuating exchange rates. This helps in promoting international trade.

9. International Investment not Promoted by Fixed Rates:

The argument that long-term international investments are encouraged under fixed exchange rate system is not valid. Both the lenders and borrowers cannot expect the exchange rate to remain stable over a very long-period.

10. Fixed Rates not Necessary for currency Area:

This stable exchange rates are not necessary for any system of currency areas. The sterling block functioned smoothly during the thirties in spite of the fluctuating rates of the member countries.

11. Speculation not Prevented by Fixed Rates:

The main weakness of the stable exchange rate system is that in spite of the strict exchange control, currency speculation is encouraged. This destroys the stability in the exchange value of the home currency and makes devaluation of the currency inevitable. For instance, the pound had to be devalued in 1949 mainly because of such speculation.

Disadvantage of Flexible Exchange Rates

The following are the main drawbacks of the system of flexible exchange rates :

1. Low Elasticities:

The elasticities in the international markets are too low for exchange rate, variations to operate successfully in bringing about automatic equilibrating adjustments. When import and export elas­ticities are very low, the exchange market becomes unstable. Hence, the depreciation of the weak currency would simply tend to worsen the balance of payments deficit further.

2. Unstable conditions:

Flexible exchange rates create conditions of instability and uncertainty which, in turn, tend to reduce the volume of international trade and foreign investment. Long-term foreign investments arc greatly reduced because of higher risks involved.

3. Adverse Effect on Economic Structure:

The system of flexible exchange rates has serious repercussion on the economic structure of the economy. Fluctuating exchange rates cause changes in the price of imported and exported goods which, in turn, destabilise the economy of the country.

4. Unnecessary Capital Movements:

The system of fluctuating exchange rates leads to unnecessary international capital movements. By encouraging speculative activities, such a system causes large-scale capital outflows and inflows, thus, seriously disturbing the economy of the country.

5. Depression Effects of Capital Movements:

Speculative capital movements caused by fluctuating ex­change rates may lead to the problem of extremely high liquidity preference. In a situation of high liquidity preference, people tend to hoard currency, interest rates rise, investment falls and there is large-scale unemployment in the economy.

6. Inflationary Effect:

Flexible exchange rate system involves greater possibility of inflationary effect of exchange depreciation on domestic price level of a country. Inflationary rise in prices leads to further depreciation of the external value of the currency.

7. Factor Immobility:

The immobility of various factors of production deprives the flexible exchange rate system of its advantages arising from the adoption of monetary and other policies for maintaining internal stability. Such policies produce desirable effects on production and employment only when supply of factors of production is elastic.

8. Failure of Flexible Rate System:

Experience of the flexible exchange rate system adopted between the two world wars has shown that it was a flop.

answer Jun 29, 2017 by Rupali Thakur