Page 208 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes exchange rates encourage international trade by making prices of goods involved in trade more
predictable. They promote economic integration. As pointed out by Johnson, “The case for
fixed rates is part of a more general argument for national economic policies conducive to
international economic integration.”
2. The second argument for a system of fixed exchange rates is that it encourages long-term capital
flows in an orderly and smooth manner. There is no uncertainty and risk resulting from a
regime of fixed exchange rates.
3. There is no fear of currency depreciation or appreciation under a system of fixed exchange
rates. For instance, it removes fear that holding large quantities of foreign currency might lead
to losses, if a currency’s value drops. Thus it creates confidence in the strength of the domestic
currency.
4. There is no fear of any adverse effect of speculation on the exchange rate, as speculative activities
are controlled and prevented by the monetary authorities under a regime of fixed exchange
rates.
5. Another advantage claimed by a system of fixed exchange rates is that it serves as an ‘anchor’
and imposes a discipline on monetary authorities to follow responsible financial policies with
countries. “Inflation will cause balance of payments deficits and reserve loss. Hence the
authorities will have to take counter-measures to stop inflation. Fixed exchange rates should,
therefore, impose ‘discipline’ on governments and stop them from pursuing inflationary policies
which are out of tune with the rest of the world.”
6. Johnson favours fixed exchange rates in the ‘banana republics’ where foreign trade plays a
dominant role. Flexible exchange rates in them lead to inflation and depreciation when the
exchange rate falls.
Demerits of Fixed Exchange Rates

The following arguments are advanced against a system of fixed exchange rates :
1. The principle defect in the operation of a system of fixed exchange rates is the sacrifice of the
objectives of full employment and stable prices at the alter of stable exchange rates. For example,
balance of payments adjustment under fixed exchange rates of a surplus country can take place
through a rise in prices. This is bound to impose large social costs within the country.
2. Again, under this system, the effects of unexpected disturbances in the domestic economy are
transmuted abroad. “While a country may be protected by fixed exchange rates from the full
consequences of domestic disturbances and policy mistakes, it has to bear a share of the burden
of the disturbances and mistakes of others. For to the extent that excess demand ‘leaks out’ of
the country where it was originally created, it ‘leaks in’ (via a balance of payments surplus) to
that country’s trading partner.”
3. Under it, large reserves of foreign currencies are required to be maintained. Countries with
balance of payments deficits must have large reserves if they want to avoid devaluation. If
countries wish to remain on the fixed exchange rate system, they must hold large reserves of
foreign currencies. This also imposes a heavy burden on the monetary authorities for managing
foreign exchange reserves.
4. This system requires complicated exchange control measures which lead to malallocation of
the economy’s resources.
5. Another problem relates to the stability of the exchange rate. The exchange rate of a country
vis-a-vis another country cannot remain fixed for sufficiently long period. Balance of payments
problems and fluctuations in international commodity prices often compel countries to bring
changes in exchange rates. Thus it is not possible to have rigidly fixed exchange rates.
In fact, a regime of fixed exchange rates presupposes uniformity of domestic policy objectives and
response of prices to fluctuations in demand. Such a system would undoubtedly run into severe
difficulties in the present-day world. This is because there is a reluctance to be committed to the
harmonisation of domestic policy objectives; prices respond only in a limited fashion of fluctuations

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