EXCHANGE RATES FIXED EXCHNAGE RATe An exchange rate

EXCHANGE RATES

FIXED EXCHNAGE RATe An exchange rate regime, also known as the pegged exchange rate, wherein the government and central bank attempts to keep the value of the currency is fixed against the value of other currencies, is called fixed exchange rate.

Flexible Exchange Rate • A monetary system, wherein the exchange rate is set according to the demand supply forces, is known as flexible or floating exchange rate. The economic position of the country determines the market demand supply for its currency. • In this system, the currency price is market determined, concerning other currencies, i. e. the higher the demand for a particular currency, the higher is its exchange rate and the lower the demand, the lesser is the value of currency compared to other currencies. Therefore, the exchange rate is not under the control of the government or central bank.

FIXED vs Floating Exchange Rate

Advantages of fixed exchange rates 1. Avoid currency fluctuations. If the value of currencies fluctuates, significantly this can cause problems for firms engaged in trade. For example, if a firm is exporting, a rapid appreciation in Sterling would make its exports uncompetitive and therefore may go out of business. • If a firm relies on imported raw materials, a devaluation would increase the costs of imports and would reduce profitability. 2. Stability encourages investment. The uncertainty of exchange rate fluctuations can reduce the incentive for firms to invest in export capacity. Some Japanese firms have said that the UK’s reluctance to join the Euro and provide a stable exchange rate makes the UK a less desirable place to invest. A fixed exchange rate provides greater certainty and encourages firms to invest. 3. Keep inflation low. Governments who allow their exchange rate to devalue may cause inflationary pressures to occur. Devaluation of a currency can cause inflation because AD increases, import prices increase and firms have less incentive to cut costs. 4. Current account. A rapid appreciation in the exchange rate will badly affect manufacturing firms who export; this may also cause a worsening of the current account.

Disadvantages of fixed exchange rates • 1. Conflict with other macroeconomic objectives. • To maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives. • If a currency is under pressure and falling – the most effective way to increase the value of a currency is to raise interest rates. This will increase hot money flows and also reduce inflationary pressures. However higher interest rates will cause lower aggregate demand (AD) and lower economic growth, If the economy is growing slowly this may cause a recession and rising unemployment. • 2. Less flexibility. In a fixed exchange rate, it is difficult to respond to temporary shocks. For example, if the price of oil increases, a country which is a net oil importer will see a deterioration in the current account balance of payments. But in a fixed exchange rate, there is no ability to devalue and reduce current account deficit. •

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.

Disadvantages of Flexible Exchange Rate 1. 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. 2. 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. 3. 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.