Introduction
The choice between a fixed exchange rate and a flexible (floating) exchange rate system is one of the fundamental decisions in macroeconomic policy. Both systems have their respective advantages and disadvantages, and their effectiveness depends on the country’s economic structure, development level, and exposure to global markets.
Fixed Exchange Rate System
In a fixed exchange rate system, the value of a country’s currency is pegged to another major currency (such as the US Dollar) or a basket of currencies or commodities like gold.
Merits of Fixed Exchange Rate
- Stability in Foreign Trade: Provides certainty for exporters and importers due to stable currency values.
- Encourages Investment: Predictability of returns in international trade boosts investor confidence.
- Controls Inflation: Tying currency to a low-inflation currency (like USD) can help control domestic inflation.
- Prevents Speculation: Reduces exchange rate volatility and speculative attacks in theory.
Demerits of Fixed Exchange Rate
- Loss of Monetary Autonomy: The country cannot use independent monetary policy as interest rates are directed at maintaining the peg.
- Vulnerability to External Shocks: If the currency is overvalued or undervalued, it can lead to trade imbalances.
- Needs Large Foreign Reserves: To maintain the peg, central banks need to hold significant reserves.
- Can Become Unsustainable: Persistent pressure on currency due to trade deficits can lead to a sudden collapse (e.g., Argentina 2001, UK 1992).
Flexible Exchange Rate System
In a flexible exchange rate system, currency value is determined by market forces — demand and supply for foreign exchange.
Merits of Flexible Exchange Rate
- Monetary Policy Independence: Central banks can use interest rate and money supply to target inflation or growth.
- Automatic Adjustment: Trade imbalances adjust automatically — deficit leads to depreciation, making exports cheaper and imports costlier.
- No Need for Foreign Reserves: Governments don’t need to intervene frequently in foreign exchange markets.
- Absorbs External Shocks: Currency adjusts to global changes, reducing the impact of commodity price fluctuations or capital flow volatility.
Demerits of Flexible Exchange Rate
- Volatility: Exchange rates may fluctuate significantly, affecting business planning and investment.
- Speculation: High volatility attracts speculators, which can destabilize the currency and the broader economy.
- Imported Inflation: Depreciation of currency can increase import prices and fuel inflation.
- Undermines Discipline: No external constraint may lead to irresponsible fiscal and monetary policy.
Comparison Table
| Criteria | Fixed Exchange Rate | Flexible Exchange Rate |
|---|---|---|
| Monetary Policy | Restricted | Independent |
| Price Stability | High | Low due to volatility |
| Speculation | Lower | Higher |
| Trade Competitiveness | May be distorted | Adjusts naturally |
| Foreign Reserves | High requirement | Minimal need |
Hybrid or Managed Float System
Most countries now adopt a managed float system, combining both fixed and flexible elements. Central banks intervene occasionally to stabilize excessive fluctuations.
Example: India’s exchange rate is officially market-determined, but RBI intervenes to prevent volatility.
Conclusion
Both fixed and flexible exchange rate systems have their merits and demerits. Fixed exchange rates offer stability but at the cost of policy autonomy. Flexible exchange rates allow adjustments and independence but are prone to volatility. The choice between them depends on a country’s economic objectives, structure, and external vulnerabilities. A managed float, striking a balance between the two, has become the most popular system in today’s globalized economy.