What are the main advantages and disadvantages of Fixed Exchange Rates ?

Advantages of Fixed Exchange Rates

The main arguments advanced in favor of the system of fixed or stable exchange rates are as follows:

1. Promotes International Trade:

Fixed or stable exchange rates ensure certainty about the foreign payments and inspire confidence among the importers and exporters. This helps to promote international trade.

2. Necessary for Small Nations:

Fixed exchange rates are even more essential for the smaller nations like the U.K., Denmark, Belgium, in whose economies foreign trade plays a dominant role. Fluctuating exchange rates will seriously affect the process of economic growth in these economies.

3. Promotes International Investment:

Fixed exchange rates promote international investments. If the exchange rates are fluctuating, the lenders and investors will not be prepared to lend for long-term investĀ­ments.

4. Removes Speculation:

Fixed exchange rates eliminate the speculative activities in the international transactions. There is no possibility of panic flight of capital from one country to another in the system of fixed exchange rates.

5. Necessary for Small Nations:

Fixed exchange rates arc even more essential for the smaller nations like the U.K., Denmark, Belgium, in whose economies foreign trade plays a dominant role. Fluctuating exchange rates will seriously disturb the process of economic growth of these economies.

6. Necessary for Developing Countries:

Fixed exchanges rates are necessary and desirable for the developing countries for carrying out planned development efforts. Fluctuating rates disturb the smooth process of economic development and restrict the inflow of foreign capital.

7. Suitable for Currency Area:

A fixed or stable exchange rate system is most suitable to a world of currency areas, such as the sterling area. If the exchange rates of the countries in the common currency area are flexible, the fluctuations in the leading country, like England (whose currency dominates), will also disturb the exchange rates of the whole area.

8. Economic Stabilization:

Fixed foreign exchange rate ensures internal economic stabilization and checks unwarranted changes in the prices within the economy. In a system of flexible exchange rates, the liquidity preference is high because the businessmen will like to enjoy wind fall gains from the fluctuating exchange rates. This tends to Increase price and hoarding activities in country.

9. Not Permanently Fixed:

Under the fixed exchange rate system, the exchange rate does not remain fixed or is permanently frozen. Rather the rate is changed at the appropriate time to correct the fundamental disequilibrium in the balance of payments.

10. Other Arguments:

Besides, the fixed exchange rate system is also beneficial on account of the following reasons.

(i) It ensures orderly growth of world's money and capital markets and regularises the international capital movements.

(ii) It ensures smooth functioning of the international monetary system. That is why, IMF has adopted pegged or fixed exchange rate system.

(iii) It encourages multilateral trade through regional cooperation of different countries.

(iv) In modern times when economic transactions and relations among nations have become too vast and complex, it is more useful to follow a fixed exchange rate system.

Disadvantages of Fixed Exchange Rates

The system of fixed exchange rates has been criticized on the following grounds:

1. Outmoded System:

Fixed exchange rate system worked successfully under the favorable conditions of gold standard during 19th century when

(a) the countries permitted the balance of payments to influence the domestic economic policy;

(b) there was coordination of monetary policies of the trading countries;

(c) the central banks primarily aimed at maintaining the external value of the currency in their respective countries; and

(d) the prices were more flexible. Since all these conditions are absent today, the smooth functioning of the fixed exchange rate system is not possible.

2. Discourage Foreign Investment:

Fixed exchange rates are not permanently fixed or rigid. Therefore, such a system discourages long-term foreign investment which is considered available under the really fixed exchange rate system.

3. Monetary Dependence:

Under the fixed exchange rate system, a country is deprived of its monetary independence. It requires a country to pursue a policy of monetary expansion or contraction in order to maintain stability in its rate of exchange.

4. Cost-Price Relationship not Reflected:

The fixed exchange rate system does not reflect the true cost-price relationship between the currencies of the countries. No two countries follow the same economic policies. Therefore the cost-price relationship between them go on changing. If the exchange rate is to reflect the changing cost-price relationship between the countries, it must be flexible.

5. Not a Genuinely Fixed System:

The system of fixed exchange rates provides neither the expectation of permanently stable rates as found in the gold standard system, nor the continuous and sensitive adjustment of a freely fluctuating exchange rate.

6. Difficulties of IMF System:

The system of fixed or pegged exchange rates, as followed by the International Monetary Fund (IMF), is in reality a system of managed flexibility.

It involves certain difficulties, such as deciding as to

(a) when to change the external value of the currency,

(b) what should be acceptable criteria for devaluation; and

(c) how much devaluation is needed to reestablish equilibrium in the balance of payments of the devaluing country.