Under inconvertible paper money standard, there can be two types of exchange rates – fixed and flexible. Under the present monetary system of the International Monetary Fund (IMF), fixed or stable exchange rates are known as pegged exchange rates or par values.
In fact, IMF was established with the object of stabilising the rates of exchange, with proper safeguards for adjustments whenever necessary. On the other hand, free or flexible exchange rates are left uninterrupted by the monetary authorities to be determined by the conditions of demand for and supply of foreign exchange and are perfectly free to fluctuate according to the changes in the demand or supply forces, if there are no restrictions on buying and selling in the foreign exchange market.
The free or floating rate is allowed to seek its own level, as no par of exchange is fixed. Sometimes when a currency is floated, a former fixed par no longer applies, and the government also does not care to enforce it.
Under the system of fixed pars, as adopted by the IMF member nations, the exchange rate is determined by the government and enforced either by pegging operations, or by resorting to some form of exchange control and sometimes by a healthy combination of both these methods. Under the pegging operation, the government fixes an official par of exchange and tries to enforce it through central bank or a kind of exchange stabilisation fund which enter the foreign exchange market and purchase its currency when the market rate falls below the specified level and sell it when the rate rises above a particular mark.
This system of pegged rates of exchange is government propped up. There is, however, one major defect in this system that if the market rate of exchange has a consistent tendency to decline, pegging operations would be very expensive, as it would lead to a heavy reduction in the exchange reserves of the country concerned.
Recently, therefore, it has been held by many that the IMF’s system of adjustable stable exchange rates” is not desirable and that free or fluctuating exchange rates would be more helpful in adjusting prevailing rates of exchange to their true value. Thus, there has been a heated controversy as to which of these two rates, fixed and flexible, should be preferred and why.