Flexible exchange rates do not require vast foreign exchange reserves. Flexible exchange rates are helpful to do away with barrier to trade and capital movements. It is because of these drawbacks of the freely fluctuating exchange rate that countries attach importance to ‘managed exchange rate’ with their central banks buying and selling currencies in the foreign exchange market so as to moderate the degree of fluctuations as far as practicable. Fluctuating exchange rates cause changes in the price of imported and exported goods which, in turn, destabilise the economy of the country. The immobility of various factors of production deprives the flexible exchange rate system of its advantages arising from the adoption of monetary and other policies for maintaining internal stability. The monetary policy of a country is not limited or affected by the economic conditions of other countries. A floating exchange rate is determined by the private market based on supply and demand whereas the fixed rate is decided by the central bank. Advantages and Disadvantages of Flexible Exchange Rate Systems. Disadvantages of a floating exchange rate High level of exposure to exchange rate volatility By nature, floating exchange rates are volatile and prone to sharp fluctuations. Thus, the problem of international liquidity is automatically solved. TOS4. The changes in exchange rates are more frequent and larger than the underlying fundamentals imply. The chief merit of the freely fluctuating exchange rate is that the BOP disequilibrium gets corrected automatically with the change in exchange rate. India follows a managed floating rate system. TOS Since exchange rate is not pegged under the floa­ting arrangement of exchange rate, the central bank of a country need not hold adequate foreign exchange reserves as a buffer against unforeseen developments in international trade. It is self-correcting. Advantages: (i) Automatic Adjustment in BOP: The chief merit of the freely fluctuating exchange rate is that the BOP disequilibrium gets corrected automatically with the change in exchange rate. Inflationary rise in prices leads to further depreciation of the external value of the currency. Advantage of Floating Exchange Rates: Floating exchange rates have the following advantages: 1. Before publishing your Articles on this site, please read the following pages: 1. More than $5 trillion is traded in the currency markets on a daily basis, an enormous sum by any measure. A Flexible Exchange Rate System is a theoretical model that allows for exchange rates of currencies to be determined by supply and demand. Exchange rate risk: The main disadvantage of flexible exchange rates is their volatility. Market is cleared off automatically through changes in exchange rates and the possibility of scarcity or surplus of any currency does not exist. It permits quicker adjustments in the exchange rate to changes in macro-economic factors such as changes in inflation rate, growth rate, and interest rates. Solutions to Balance of Payment Problems: The system of flexible exchange rates automatically removes the disequilibrium in the balance of payments. Of course the rate changing will affect price and thus sales. High cost of imported goods then fuels inflationary tendencies. Pros of a Fixed/Pegged Rate . The system of flexible exchange rates eliminates the need for official foreign exchange reserves, if the individual governments do not employ stabilization funds to influence the rate. Flexible exchange rate system is claimed to have the following advantages: Under flexible exchange rate system, a country is free to adopt an independent policy to conduct properly the domestic economic affairs. In other words, pegged exchange rate requires a change in domestic macroeconomic policies like deflationary policies of price and output reduction. This should reduce the negative impact of any external shocks. Answer. This has several advantages, particularly for smaller or developing economies. Advantages and Disadvantages‎ > ‎ High and Low exchange rates. A fixed exchange rate system is designed to ensure that the value of a currency stays within a very narrow range. Advantages and Disadvantages of Freely Floating Exchange Rates The freely floating currency system is the predominant system of foreign exchange that is prevalent in the world today. But, under flexible exchange rate system, a government can adopt independent monetary policy. 11. Disadvantages: 1. Flexible Exchange Rate Advantages. Advantages and disadvantages of floating exchange rates Advantages of floating exchange rates Protection from external shocks - if the exchange rate is free to float, then it can change in response to external shocks like oil price rises. Now that you know the basic difference between the two, here’s a look at what makes a floating exchange rate good or bad: List of Pros of Floating Exchange Rate. Disclaimer Under this system, the threat of ‘importing inflation’ from outside the country is minimum. Fixed Exchange Rates or Flexible Exchange Rates – Which One is better? Disclaimer Copyright, Share Your Knowledge And as demand of products less, will cause less co… FLEXIBLE EXCHANGE RATE SYSTEM Flexible exchange rate system works with change in supply and demand of the currency world wide. Flexible exchange rates allow for fully independent domestic policies. In a flexible exchange rate, the domestic economy remains insulated from external shocks and pressures. Helping the government maintain low inflation, which can have positive long-term effects such as keeping do… Privacy Policy3. In a situation of high liquidity preference, people tend to hoard currency, interest rates rise, investment falls and there is large-scale unemployment in the economy. Fixed Rates not Necessary for currency Area: This stable exchange rates are not necessary for any system of currency areas. By nature, flexible exchange rate is inflationary. In clean floa view the full answer 1. Providing greater certainty for importers and exporters, therefore encouraging more international trade and investment. The exchange rates can be changed in accordance with the requirements of the monetary policy of the country to achieve the planned national objectives. Experience of the flexible exchange rate system adopted between the two world wars has shown that it was a flop. Speculation not Prevented by Fixed Rates: The main weakness of the stable exchange rate system is that in spite of the strict exchange control, currency speculation is encouraged. All the articles you read in this site are contributed by users like you, with a single vision to liberate knowledge. Fixed versus Flexible. Countries prefer a fixed exchange rate regime for the purposes of export and trade. Thus, greater the speculation against a currency, the deeper the economic crises. In other words, this study would consider what impact fixed and flexible exchange rates have had on the Nigerian economy over the years. Flexible exchange rates eliminate the need for central banks to hold international reserves. PreserveArticles.com is an online article publishing site that helps you to submit your knowledge so that it may be preserved for eternity. What are the main advantages and disadvantages of Fixed Exchange Rates ? As soon as the exchange rate falls, automatically, consequent upon the BOP deficit, import goods become expensive. 2. In fact, the present shortage of international liquidity is due to pegging the exchange rates and the intervention of the IMF authorities to prevent fluctuations in the rates beyond a narrow limit. Under the flexible exchange rate system, the foreign exchange rates are determined by the market forces of demand and supply. Before publishing your Article on this site, please read the following pages: 1. Today, most fixed exchange rates are pegged to the U.S. dollar. Flexible exchange rate system involves greater possibility of inflationary effect of exchange depreciation on domestic price level of a country. The flexible exchange rate system promotes economic development and helps to achieve full employment in the country. Fixed; Freely fixed; Managed float; Pegged; Fixed Exchange Rate System. The biggest financial market in the world is the biggest market because it provides some advantages to its participants. However, critics argue that fixed exchange rates can be difficult to maintain – it may require high-interest rates and deflating the economy – just to keep the currency at its target. Hence, the depreciation of the weak currency would simply tend to worsen the balance of payments deficit further. 10. The dollar is used for most transactions in international trade. China, currently has the strongest economy in the world with positive balance of payment since mid of 1990s, its foreign exchange reserve also has been increasing drastically at the same time from around 150 billion USD to 1600 billion USD in 2007, more than 10 times in less than 20 years (Research Institute of Economy, Trade & Industry, 2008).Such a large economy scale with … Floating exchange rates also have disadvantages. CIC2006 GLOBAL FINANCE Tutorial Exercise 1: 1. Fiscal policy effective (higher rates attracts dollars, increase in MS to avoid appreciation leads to more expansion) FLEXIBLE Advantages ER adjusts to shocks and imbalances Less vulnerable to speculative attacks Monetary policy effective No need to raise interest rates or cause recession to defend the ER Disadvantages Let us make an in-depth study of the advantages and disadvantages of the flexible exchange rate system. What are the Advantages of Flexible Exchange Rates? Share Your PPT File. For instance, the pound had to be devalued in 1949 mainly because of such speculation. As a result, export tends to rise while imports tend to decline—thereby removing deficit in the BOP account. In India, it is a flexible exchange rate which is being determined. In other words, under this system of exchange rate, internal balance could be maintained by the government. Fixed or stable exchange rates ensure certainty about the foreign payments and inspire confidence among the importers and exporters. Exchange rate systems normally fall into one of the following categories, each of which is discussed in turns:. Content Guidelines 2. Flexible exchange rates A. do not allow a country to use expansionary monetary policy to combat recessions, but currency values fluctuate substantially, introducing uncertainty into international transactions Similarly, supply in the BOP account means excess demand for home currency and, thus, rise in the exchange rate. 4. This helps in promoting international trade. The sterling block functioned smoothly during the thirties in spite of the fluctuating rates of the member countries. PreserveArticles.com is a free service that lets you to preserve your original articles for eternity. Advantages of fixed exchange rates. 3. What are the advantages and disadvantages of fixed exchange rates? Flexible exchange rate encourages wide speculation since foreign exchange prices are not known in advance as in fixed exchange rate. 5. The advantages of a fixed exchange rate include: 1. Fixed Rate: An Overview . Briefing Exploring Issues with Dr André Haughton THE JAMAICAN economy is now primed for growth, and there have been some discrepancies as to whether or not a floating exchange-rate regime has been the most suitable approach to currency management, or would it be better if the country adopts a less flexible-exchange rate system. A fixed exchange rate is when a country ties the value of its currency to some other widely-used commodity or currency. Share Your Word File Suppose an Indian has despatched an export ‘invoice’ to the foreign buyers. Advantages of Forex Market. Restrictions on international trade are removed and there is free movement of capital and money between countries. ADVERTISEMENTS: Let us make an in-depth study of the advantages and disadvantages of the flexible exchange rate system. Hence—it is destabilising in effect. 1. The system of flexible exchange rates has serious repercussion on the economic structure of the economy. Critically evaluate the flexible exchange rate system advantages and disadvantages. PreserveArticles.com: Preserving Your Articles for Eternity. Since all these conditions are absent today, the smooth functioning of the fixed exchange rate system is not possible. Disadvantages of the Floating Rate Uncertainty – The fact that a currency changes in value from day to day introduces instability or uncertainty into trade. What are the Advantages of Fixed Exchange Rates. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. It is because of speculation there occurs disruptive hot money flows. Privacy Policy The foreign policy does not bind the central bank in implementing its monetary policy. Some of the major advantages offered are as follows: Flexibility. Our mission is to liberate knowledge. The following are the main drawbacks of the system of flexible exchange rates : The elasticities in the international markets are too low for exchange rate, variations to operate successfully in bringing about automatic equilibrating adjustments. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. Floating Rate vs. However, economists are not unanimous about this kind of speculation associated with the flexible exchange rate system. Forex exchange markets provide traders with a lot of flexibility. But the Indian exporters do not know at what price foreign currency will be converted into Indian currency. Different Exchange Rate Systems. This destroys the stability in the exchange value of the home currency and makes devaluation of the currency inevitable. 4. As globalization has progressed, more countries have abandoned their currency pegs and have allowed their currencies to freely float. ADVANTAGES DISADVANTAGES Elimination of Uncertainty and Risk-risks associated with international trade and investment get minimized if exchange rates are fixed Inconsistent with domestic currency Speculation … The actual level of exchange rate will have marked economic effects upon a country and we need to look at these now to understand fully why governments intervene to influence the value of the exchange rate. Thus, it acts as a shock absorber and saves the internal economy from the disturbing effects from abroad. Unregulated free- floating exchange rate often discourages foreign investment as exchange rate becomes erratic and, hence, destabilising. If a BOP deficit arises, there would be an excess supply of home currency leading to a fall in exchange rate simply by the market forces of demand and supply. The disadvantage is that this creates uncertainty for importers and exporters when it comes to planning for future trades. In other words, price feedback effect is imperceptible. Copyright. The system of flexible exchange rates does not permit exchange control and promotes free trade. Floating exchange rate regimes are market … A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold.. Flexible Exchange Rate System: Advantages: 1. In the post–Bretton Woods era, one of the characteristics of flexible exchange rate is their excess volatility. It there is a situation arise such as deficit then it lead organization to be competitive again, The problem should be solve by reducing the level of aggregating demand, when there is a fixed exchange rate is used. This causes export goods cheaper and import goods dearer. For example, if … A fixed exchange rate is … Such policies produce desirable effects on production and employment only when supply of factors of production is elastic. Content Guidelines Countries also fix their currencies to that of their most frequent trading partners. 5. Flexible exchange rate: In this system, Central bank allow exchange rate to adjust to equatee demand and supply of foreign currency. In a flexible exchange rate system currency values change on a daily basis. Explain. In a fixed exchange rate system, exchange rates … ADVERTISEMENTS: In this article we will discuss about the advantages and disadvantages of floating exchange rates. An unexpected fall in the exchange rate can also be a cause of rising inflation. It gives a lot of independence to the market forces, provides data to regulators and stabilises India’s economy. Flexible exchange rate enhances the efficiency in the economy by achieving optimum: resources allocation. Their impact on Balance of Payments and Gross Domestic Product One of the main disadvantages is that floating currencies can be volatile which makes doing businesses harder. As the change in supply and demand occurs the fluctuation in rate … Surplus and deficit in the BOP accounts get corrected if foreign exchange rate falls and rises, respectively. To put it elaborately, it can be argued that when the exchange rate tends to decline, speculators anticipate that such would continue to decline further and the possibility of the flight of money to another country will brighten.