Fixed Exchange Rates or Flexible Exchange Rates – Which One is better?

Theoretical Debate over Fixed Exchange Rates and Flexible Exchange Rates

Though the debate still continues over the relative merits of (a) fixed or stable exchange rates, (b) flexible or floating exchange rates, and (c) a compromise between the two systems, it is not completely unresolved. Both theory and experience, however, have combined to resolve partly some of the key issues in the debate. These key issues are: (a) the argument of price discipline; (b) the risk argument; and (c) the argument of destabliSing speculation.

1. Argument of price Discipline:

One major argument advanced in favour of fixed rates and against flexible exchange rates is that the flexible exchange rates weaken internal price discipline and allow more inflation.

The argument runs as follows: The fixed exchange rate system puts more pressure on the deficit countries to deflate more than on the surplus countries to inflate.

Thus, allowing the governments to switch over to flexible exchange rates system will on the average release more inflationary policies. This argument is correct and is supported by the fact that world inflation increased after the generalised float of August 1971.

But, whether one considers this argument for fixed or flexible exchange rates involve value judgment. It depends upon one’s view of unemployment-inflation dilemma.

Those who care much about full employment and are not much bothered about price inflation might prefer flexible rates because the flexible rates enhance the ability of deficit countries to create jobs through expansionary policies.

On the contrary, those who fear inflation above all are more likely to favour fixed exchange rates.

2. Risk Argument:

The argument that flexible exchange rates expose traders and investors to greater risks is questionable. ‘The arguments needed to defend fixed exchange rates against the shocks that are experienced in any other system of exchange rates are likely to be less costly.

Under the flexible exchange rate system, one can easily insure against exchange rate risk through hedging in the forward market.

On the other hand, it is much harder to insure against a sudden loss of job or sudden inflation resulting from the attempts to defend fixed exchange rate system.

3. Argument of Destabilising Speculation:

The argument that flexible exchange rates breed; destabilizing speculation is not fully supported by theory or by experience. Speculation under flexible exchange rates may be stabilising or destabilising.

If the speculators expect a fall in the price of foreign exchange (e.g., fall in dollar per pound) when it is above the trend level, and expect a rise in the price of foreign exchange when it is below the trend level, they tend to sell the foreign currency (pound) when its price is above the trend and buy it when its price is below trend.

This is called stabilising speculation. On the other hand, if the speculators expect a further rise in the price of foreign currency (e.g., pound) when it is above the trend level and expect a further fall in the price of foreign currency (pound) when it is below the trend level, they tend to buy the foreign currency (pound) when its price is above trend and sell it when its price is below trend. This is a case of destabilising speculation.

According to Friedman, the destabilising speculation is self-eliminating because destabilizing speculators will be losing money by buying high and selling low over each cycle of exchange rate movement and will go bankrupt if they continue behaving in this manner.

But, the question, whether, under a flexible exchange rate system, speculation will in reality be stabilising, or destabilising is not merely a theoretical question, but also an empirical question, and has to be answered by the study of actual facts.

Such a study will bring to light many cases in which the destabilising speculators did not bother about losing money and actually lost money, but produced destabilising effects.