1. It is claimed that stable exchange rates help to promote the growth of foreign trade. But this argument is not supported by historical evidence in the post-war years. On the other hand, under a system of flexible rates, as the trend of the rate of exchange can usually be assessed through the forward market, the risk will be minimised and trade will grow.
2. Stability in exchange rates is not an absolute condition for long-term capital investment internationally. Over a very long period a lender or a borrower cannot expect the exchange rate to be stable. Moreover, if flexible exchange rates can do more than fixed rates to adjust external balances and prevent recurrent balance of payments crises, then their effect on international lending is likely to be more beneficial.
3. Stable exchange rates are not inevitable in a system of currency area like the sterling area. Typical economic, political and social forces have induced various countries to constitute the sterling bloc and these forces would not be enfeebled if the sterling is allowed to have flexible exchange rates.
4. The system of stable exchange rates has many inherent weaknesses. Even under severe exchange control, it props up currency speculation and endangers the stability in the external value of home currency, ultimately leading to devaluation. For instance, the pound had to be devalued in 1949, mainly on account of such speculation.
5. Another major drawback of the stable exchange rates system is that it does not reflect the existing and true cost-price relationship between two currencies. When countries follow different economic policies, cost-price relations alter frequently and the economic stability will be hampered.
Moreover, stable exchange rates are also responsible for the economic difficulties of one country to be passed on to other countries. For instance, the instability of Western European countries after 1945 was due to the rigid linking of their currencies to the U.S. dollar.
Thus, the advantages claimed for flexible rates are:
(i) The system of flexible exchange rates is a simple one. The exchange rate moves in a free market to equate supply and demand, so that the market is cleared off and the problem of scarcity or surplus of any one currency is automatically solved. Hence, under the flexible exchange rate system, the countries do not have to make extra efforts in inducing changes in prices and incomes in order to maintain or re-establish equilibrium in the balance of payments.
(ii) Being very sensitive, the system of flexible rates facilitates continuous adjustments, so that, the adverse effect of prolonged period of disequilibrium is avoided (which is commonly found in the present fixed rate system).
(iii) It is the only system which permits the continued existence of free trade and convertible currencies. This system does not require the use of exchange controls, which is generally associated with the system of pegged rates.
(iv) The flexible exchange rates system also confers more independence on the countries in their domestic policies.
Friedman, however, opines that the harmonisation of internal monetary policies is more likely t occur under flexible than under fixed exchange rates system. Because, flexible rates minimise the transformation of economic effects through monetary channels than otherwise might interfere with the pursuit of internal policies aimed at achieving or maintaining growth and full employment. In his view, thus, if countries follow widely divergent monetary policies, the flexible exchange rate system will not work satisfactorily. (This, however, is the case with pegged rates system too).
(v) Sohmen argues that flexible rates system tends to reinforce the effectiveness of monetary policy. For example, when a country seeks to expand output, it may lower interest rates. But the lowering of interest rate, under the flexible exchange rates systems, will cause an outflow of capital a rise in the spot rate, and a rise in exports relative to imports. The trade balance, as such will move favourable which will reinforce the expansionary effect of lower interest rate on domestic spending, thus making the monetary policy more effective.
(vi) The system of flexible exchange rates eliminates the need for official foreign exchange reserves, if individual governments do not employ stabilisation funds to influence the rate. It thus, solves the problem of international liquidity automatically. In fact, the present shortage of international liquidity is said to be on account of pegging exchange rates and the intervention of the IMF authorities to prevent fluctuations in the exchange rates beyond a narrow limit.
Under the flexible exchange rates however, the speculators would supply the foreign exchange to satisfy private liquidity needs. Although, there will be holding of liquid assets (may be in terms of gold or foreign exchange even). These holdings would be used as working reserves and not for maintaining a fixed value of currency of the country.
For these reasons, many suggest the abandonment of the so-called fixed exchange rates sys in favour of freely fluctuating exchange rates as per the market mechanism.
It must, however, be noted that except for brief intervals, no country can afford to allow its rate of exchange to float indefinitely and follow the day-to-day changes in internal and external economic situations over a long period. A randomly fluctuating exchange rate is not compatible with domestic stability. It will upset the smooth flow of international trade and disrupt the functioning of domestic economy. Prof. Nurkse remarks: “Fluctuating exchange rates cause constant shifts of domestic factors of production between export and home-market industries, shifts which may be disturbing and wasteful.”
Hence, some kind of stability is absolutely essential for the smooth working of the econ system. There should be a reasonable degree of stability, but not rigidity in the exchange rates, freedom to alter or fix the exchange rate as the country likes within prescribed limits.