What are the Advantages of Fixed Exchange Rates?

The following advantages are claimed for the system of stable or fixed exchange rates as against the flexible exchange rates:

1. Stable exchange rates ensure certainty and confidence and thereby, promote international trade. Foreigners can easily know how much they will have to pay and how much they will receive in terms of the home currency. Instability in exchange rates constitutes an additional risk in international trade which hampers its growth.

2. A system of stable exchange rates will facilitate long-term international investments. With an unstable exchange rate, lenders and investors will not be prepared to lend for long-term investment. Thus, a system of stable exchange rates is essential for the orderly growth of international investment markets.

3. A fixed rate of exchange is more suited to a world of currency areas, such as the sterling area.

4. Fixed exchange rates will remove the dangerous possibilities of speculation. In a system of stable exchange rate there will be no panic flight of capital from one country to another.

5. A stable exchange rate will also assist in internal economic stabilisation. On the other hand freely fluctuating exchange rates encourage abnormally high liquidity preference which leads to hoarding, to higher rates of interest, to shrinking of investment and to unemployment.

6. For small countries like Denmark and Great Britain in whose economy foreign trade plays a crucial role, stabilisation of the exchange rate is the only right policy. For if the country dose not stabilise her exchange rate, fluctuations in the rate of exchange will disturb her foreign trade and with it the prosperity and growth of the country.

Since the advantages of the system of stable exchange rates mentioned above are substantial and carry much weight, the IMF aimed at maintaining stable or pegged exchange rates for its members. However, in recent years, there has been a strong reaction against the fixed exchange rate system. For various reasons, most of the member countries have found it difficult to pursue a fixed exchange rate policy as desired by the IMF.

It is further held that, fixed exchange rates seemed to work well under the favourable conditions of the nineteenth century. Particularly:

(i) In the 19^th century, countries permitted the balance of payments to influence the domestic economic policy.

(ii) There used to be a coordination of monetary policies of trading countries. Surplus countries followed expansionary (cheap money) policy and deficit countries adopted restrictive (dear money) policy.

(iii) The basic goal of central banks at that time was to maintain the external value of currency.

(iv) The success of gold standard in the 19^th century was due to the fact that prices were more flexible in those days.

All these conditions are absent today. Hence, the smooth operation of a system of fixed exchange rates is not possible. Due to the inherent defects in the IMF system, the pegging of exchange rates has not been a very successful phenomenon.

The major shortcomings of the IMF are as follows:

1. Since the system of pegged rates followed by the IMF permits occasional changes in exchange rates, it turns out to be a system of managed flexibility. It involves various difficulties such as: (i) deciding as to when to change the external value of a currency; (ii) establishing acceptable criteria for devaluation; (iii) measuring the extent of devaluation needed to re-establish equilibrium in the balance of payments of the devaluating country. Further, due to more frequent exchange rate changes and the national monetary policies followed today, the need for reserves is becoming greater and greater which tends to aggravate the problem of international liquidity.

2. The system of pegged rates may cause a large-scale destabilising speculation in the foreign exchange markets. Speculation causes the movement of funds from weak to strong currencies, so that, a more drastic devaluation may force a country to resort to rigorous exchange controls.

3. Pegged rates are not permanently fixed. As such, it deters long-term foreign investment assumed to be available under genuinely fixed rates system.

4. The present system of pegged rates thus, provides neither the expectation of permanently stable rates (found in the old gold standard system) nor the continuous and sensitive adjustment of a freely fluctuating rate.

5. The monetary policies followed by the countries individually are rarely coordinated today. The objectives of achieving a high and stable level of employment and income at home and maintenance of external stability of the value of money are distinctively inconsistent.

However, the exponents of the fixed exchange rates system have mentioned the following drawbacks of flexible exchange rates:

1. The elasticities in international markets are too low for exchange rate variations to operate successfully in bringing about automatic equilibrating adjustments. When the import and export elasticities are too low, the exchange market becomes unstable, hence, the depreciation of the weak currency would simply tend to worsen the deficit payment further.

2. The flexible exchange rates system leads to instability and uncertainly, which cause reduction in the volume of international trade and investments below optimum levels. No doubt, the system of flexible exchange rates will greatly curtail long-term foreign investments, because it increases the risks.

The proponents of the flexible rate system, however, argue that for the long-term investment the risk may not be much different in any system of exchange rates – whether, it is fixed or flexible. Moreover, risk due to exchange control in the pegged rate system is greater, which deters long-term investments much more than the risk involved in variations of flexible rates.

Critics, however, hold that the flexible rates system would restrict commodity trade because buyers and sellers will be reluctant to make commitments due to uncertainty of exchange rates, thus, affecting the profitability of foreign trade.

3. Speculation will be forceful in a flexible exchange rate system which will have a destabilising effect, causing further fluctuations.

4. Flexible exchange rate system involves greater possibility of inflationary effect of exchange depreciation on the domestic price level of a country, causing a further depreciation. The pegged exchange rate system, on the other hand, imposes a strong discipline on the domestic policies to prevent inflation in order to maintain the external value of the currency.

5. The immobility of factors of production deprives the flexible rates system of its advantage in free monetary and other policies used for maintaining internal stability.

6. Experience of flexible rates system followed between the two world war periods shows that it was a flop.

The supporters of the flexible rates system, however, argue that, the cause of its failure was due to unwise financial policies of many governments and other unfavourable circumstances.