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

in the pressures of demand, and elasticities of demand in international trade have in general turned Notes
out to be quite low, at least in the short run. For these reasons, a rigidly fixed exchange rate regime
has never been advanced as serious possibility in any of the recent discussions of reform of the
international monetary system.
18.2 Merits and Demerits of Flexible Exchange Rate

Flexible, floating or fluctuating exchange rates are determined by market forces. The monetary authority
does not intervene for the purpose of influencing the exchange rate. Under a regime of freely fluctuating
exchange rates, if there is an excess supply of a currency, the value of that currency in foreign exchange
markets will fall. It will lead to depreciation of the exchange rate. Consequently, equilibrium will be
restored in the exchange market. On the other hand, shortage of a currency will lead to appreciation
of exchange rate thereby leading to restoration of equilibrium in the exchange market. These market
forces operate automatically without any intervention on the part of monetary authorities. We study
below the case for and against flexible exchange rates.
Merits of Flexible Exchange Rates

The following merits are claimed for a system of flexible exchange rates :
1. A system of flexible exchange rates is simple in the operative mechanism. The exchange rate
moves automatically and freely to equate supply and demand, thereby clearing the foreign
exchange market. It does not allow a deficit or surplus to build up and eliminates the problem
of scarcity or surplus of any one currency. It also avoids the need to induce changes in prices
and incomes to maintain or restore equilibrium in the balance of payments.
2. Under it, the adjustment is continual. The adjustment in the balance of payments are smoother
and painless as compared with the fixed exchange rate adjustments. In fact, flexible exchange
rates avoid the aggravation of pressures on the balance of payments and the periodic crises that
follow disequilibrium in the balance of payments under a system of fixed exchange rates. There
is an escape from the various corrective measures that are adopted by the governments whenever
the exchange rate depreciates or appreciates.
3. Under this system, autonomy of the domestic economic policies is preserved. Modern
governments are committed to maintain full employment and promote stability with growth.
They are not required to sacrifice these objectives of full employment and economic growth in
order to remove balance of payments disequilibrium under a regime of flexible exchange rates.
As pointed out by Johnson, “ The fundamental argument for flexible exchange rates is that they
allow countries autonomy with respect to their use of monetary, fiscal and other policy
instruments, by automatically ensuring the preservation of external equilibrium.”
4. Since under a system of flexible exchange rates disequilibrium in the balance of payments is
automatically corrected, there is no need to accommodate gold movements and capital flows in
and out of countries.
5. There is no need for foreign exchange reserves where exchange rates are moving freely. A
deficit country will simply allow its currency to depreciate in relation to foreign currency instead
of intervening by supplying foreign exchange reserves to the other country to maintain a stable
exchange rate. According to Sohmen, a system of flexible exchange rates removes the problem
of international liquidity. The shortage of international liquidity is the result of pegged exchange
rates and intervention by monetary authorities to prevent fluctuations beyond narrow limits.
When exchange rates are flexible, speculators will supply foreign exchange to satisfy private
liquidity needs. Individuals, traders, banks, governments and others would, of course, continue
to hold liquid assets in the form of gold or foreign exchange, but these holdings would be
working reserves for purposes other than the maintenance of a fixed external value of the
country’s currency.
6. As a corollary to the above, when foreign exchange rates move freely, there is no need to have
international institutional arrangements like the IMF for borrowing the lending short-term funds
to remove disequilibrium in the balance of payments.

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