The document discusses fixed and flexible exchange rate systems, detailing the mechanisms, advantages, and disadvantages of each. Fixed exchange rates provide stability, eliminate speculation, and support responsible macroeconomic policies but can encourage speculation during balance of payments crises, while flexible rates allow for independent monetary policy and act as shock absorbers but may lead to unnecessary capital movements and inflation. Overall, the choice between fixed and flexible systems involves trade-offs impacting trade, investment, and economic stability.

1. Fixed & Flexible Exchange Rate System

2. Fixed exchange rate
 Fixed exchange rate is the rate which is officially fixed by the government or
monetary authority and not determined by market forces.
 Only a very small deviation from this fixed value is possible. In this system, foreign
central banks stand ready to buy and sell their currencies at a fixed price.
 A typical kind of this system was used under Gold Standard System in which
each country committed itself to convert freely its currency into gold at a fixed price.
 In other words, value of each currency was defined in terms of gold and, therefore,
exchange rate was fixed according to the gold value of currencies that have to be
exchanged.

3. Advantages
1. Elimination of Uncertainty and Risk
 The necessary condition for an orderly and steady growth of trade demands stability
in exchange rate. Any undue fluctuations in exchange rate cause problems to the
plans and programs of both exporters and imports.
 In other words, incomes of export-earners and the cost of imports of the importers
tend to become uncertain if the exchange rate fluctuates. This uncertainty can be
removed by a fixed exchange rate method.
 Further, the risks associated with international trade and investment get minimized
largely if exchange rates are not allowed to vary.

4. 2. Speculation Deterred
 As exchange rate remains unchanged for a fairly long period of time, people expect
that such rate would not change in the immediate future. This then eliminates
speculation in the foreign exchange market.
 Further, as stability in the exchange rate over longish period eliminates the
threat of speculation, it discourages the flight of capital.
In a world of free fluctuating exchange rate, the danger of the flight of capital is
rather high as this kind of exchange rate induces people to speculate.
As exchange rates remain fixed, traders have a sense of confidence that
international payments can be made safely without the danger of losses.

5. 3. Prevention of Depreciation of Currency
 In poor developing countries, one experiences BOP difficulties of a permanent type.
 Under the circumstances, any frequent changes in exchange rate will tend to
aggravate the BOP crisis, like continuous depreciation of home currency in terms of
currencies of other countries.
 In other words, unstable exchange rates result in depreciation of currencies. This can
be prevented by the stable exchange rate.

6. 4. Adoption of Responsible Macroeconomic Policies
Stable exchange rate system prevents government from adopting irresponsible
macro- economic policies like devaluation of currencies.
 Above all, under the fixed exchange rate system, deflationary policies can even be
pursued to tide over the BOP deficit, even without bringing any change in domestic
policies.

7. Attraction of Foreign Investment
 Exchange rate stability may encourage foreigners to perk their investible funds in a
country.
If the exchange rate changes rather frequently, it will deter them to invest in a
country. Of course, such foreign investment having multiplier effect leads to higher
economic growth.

8. Anti-inflationary
Fixed exchange rate system is anti-inflationary in character.
If exchange rate is allowed to decline, import goods tend to become dearer.
 High cost import goods then fuel inflation. Such a situation can be prevented by
making the exchange rate fixed

9. Disadvantages
 Speculation Encouraged In fact, uncertainty and, hence, speculative activities, tend
to get a boost even under the fixed exchange rate system.
Under a fixed rate system, if a country faces huge BOP deficit then the possibility of
speculation gets brightened.
 If the speculators can guess that such BOP deficit will persist in the days ahead and
the authority may go for a cut in foreign exchange rate then these people will be more
enthusiastic to sell domestic currencies in the foreign exchange market.
 If such sale of home currencies continues for a longer period, the central bank will
then be forced to reduce exchange rate, instead of keeping it at the old fixed rate.
Under the circumstance, speculators go on buying home currencies where exchange
rates have been reduced.

10. Adequacy of Foreign Exchange Reserves
 For the effectiveness of a stable exchange rate, the necessary condition is the
adequacy of holding, foreign exchange reserves.
 Poor developing countries find it difficult to maintain an adequate volume of foreign
exchange reserves.
 Speculators then anticipate currency devaluation in advances if BOP needs to be
corrected.
 Before 1970, fixed exchange rate, in fact, prevailed because of low volume of global
trade and, hence, low volume of foreign exchange reserves

11. Internal Objectives of Growth and Full Employment Sacrificed
When countries experience large and persistent deficits or ‘fundamental
disequilibrium’in BOP, they are down with the foreign exchange reserves.
Countries then opt for devaluation of their currencies and take some internal
measures to reduce their deficits.
These harsh internal measures tend to contract economies. But the fallouts of these
measures are rising prices and rising unemployment.
These then reduce economic growth.

12. Flexible (Floating) Exchange Rate System
 The system of exchange rate in which rate of exchange is determined by forces
of demand and supply of foreign exchange market is called Flexible Exchange
Rate System.
 Here, value of currency is allowed to fluctuate or adjust freely according to change
in demand and supply of foreign exchange.
 There is no official intervention in foreign exchange market.
Under this system, the central bank, without intervention, allows the exchange
rate to adjust so as to equate the supply and demand for foreign currency In
India, it is flexible exchange rate which is being determined.
The foreign exchange market is busy at all times by changes in the exchange rate.

13. Advantage
1. Independent Monetary Policy Under flexible exchange rate system, a country is
free to adopt an independent policy to conduct properly the domestic economic
affairs. The monetary policy of a country is not limited or affected by the economic
conditions of other countries.
2. Shock Absorber A fluctuating exchange rate system protects the domestic
economy from the shocks produced by the disturbances generated in other
countries. Thus, it acts as a shock absorber and saves the internal economy from the
disturbing effects from abroad.
3. Promotes Economic Development The flexible exchange rate system promotes
economic development and helps to achieve full employment in the country. The
exchange rates can be changed in accordance with the requirements of the monetary
policy of the country to achieve the planned national objectives.

14. 4. Solutions to Balance of Payment Problems
The system of flexible exchange rates automatically removes the disequilibrium in
the balance of payments. When, there is deficit in the balance of payments, the external
value of a country’s currency falls. As a result, exports are encouraged, and imports are
discouraged thereby, establishing equilibrium in the balance of payment.
5. Promotes International Trade
The system of flexible exchange rates does not permit exchange control and promotes free
trade. Restrictions on international trade are removed and there is free movement of
capital and money between countries.
6. Increase in International Liquidity
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. Thus, the problem of international liquidity is automatically solved.

15. Disadvantage
Unnecessary Capital Movements
The system of fluctuating exchange rates leads to unnecessary international capital
movements. By encouraging speculative activities, such a system causes large-scale
capital outflows and inflows, thus, seriously disturbing the economy of the country.
Depression Effects of Capital Movements
Speculative capital movements caused by fluctuating exchange rates may lead to the
problem of extremely high liquidity preference. 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.
Inflationary Effect
Flexible exchange rate system involves greater possibility of inflationary effect of
exchange depreciation on domestic price level of a country. Inflationary rise in prices
leads to further depreciation of the external value of the currency.