Page 206 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance Pavitar Parkash Singh, Lovely Professional University

Notes Unit 18 : Merits and Demerits of Fixed and
Flexible Exchange Rate

CONTENTS
Objectives
Introduction
18.1 Merits and Demerits of Fixed Exchange Rate
18.2 Merits and Demerits of Flexible Exchange Rate
18.3 Summary
18.4 Key-Words
18.5 Review Questions
18.6 Further Readings

Objectives

After reading this Unit students will be able to:
• Know the Merits and Demerits of Fixed Exchange Rate.
• Describe the Merits and Demerits of Flexible Exchange Rate.
Introduction

In the previous unit we discussed the various theories relating to the determination of exchange rate
under different exchange rate regimes. The present unit discusses the exchange rate adjustment policies
that have been in vogue from time to time with the establishment of the IMF. Before we discuss them,
it is instructive to have a theoretical interlude relating to fixed and fluctuating exchange rates.
18.1 Merits and Demerits of Fixed Exchange Rate

Under fixed or pegged exchange rates all exchange transactions take place at an exchange rate that is
determined by the monetary authority. It may fix the exchange rate by legislation or intervention in
currency markets. It may buy or sell currencies according to the needs of the country or may take
policy decision to appreciate or depreciate the national currency. The following arguments are usually
advanced for and against the system of fixed exchange rates.
Merits of Fixed Exchange Rates

Economic Advantages of a Fixed Exchange Rate : As with a hard peg, a fixed exchange rate has the
advantage of promoting international trade and investment by eliminating exchange rate risk. Because
the arrangement may be viewed by market participants as less permanent than a currency board,
however, it may generate less trade and investment.
As with a hard peg, the drawback of a fixed exchange rate is that it gives the government less scope
to use monetary and fiscal policy to promote domestic economic stability. Thus, it leaves countries
exposed to idiosyncratic shocks not shared by the country to which it has fixed its currency. As
explained above, this is less of a problem than with a hard peg because imperfect capital mobility
does allow for some deviation from the policy of the country or countries to which you are linked.
But the shock would need to be temporary in nature because a significant deviation could not last.
The scope for the pursuit of domestic goals is greater for countries that fix their exchange rate to a
basket of currencies — unlike a hard peg, the country is no longer placed at the mercy of the unique

200 LOVELY PROFESSIONAL UNIVERSITY