Q.Distinguish between fixed exchange rate system and flexible exchange rate system.
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Start your 14-day free trial to unlock the full solution →A fixed exchange rate system involves a government or central bank actively maintaining a specific exchange rate, while a flexible exchange rate system allows market forces of demand and supply to determine the exchange rate freely.
Understanding how a country's currency exchanges for another is fundamental to international trade and finance. An exchange rate system refers to the set of rules, arrangements, and institutions that govern how a country manages its currency in relation to other currencies. The two primary types of exchange rate systems are fixed and flexible.
Fixed Exchange Rate System
In a fixed exchange rate system, a country's government or central bank officially pegs the value of its currency to another major currency (like the US dollar), a basket of currencies, or a commodity like gold. The core idea here is stability and predictability. The central bank commits to maintaining this fixed rate, and it does so through active intervention in the foreign exchange market.
Mechanism:
When the market forces try to push the exchange rate away from the fixed peg, the central bank steps in.
- If the domestic currency's value tends to fall (depreciate) below the fixed rate, meaning there's an excess supply of domestic currency or excess demand for foreign currency, the central bank will sell its foreign currency reserves (e.g., US dollars) and buy its own domestic currency. This increases the demand for the domestic currency, pushing its value back up to the peg.
- Conversely, if the domestic currency's value tends to rise (appreciate) above the fixed rate, meaning there's an excess demand for domestic currency or excess supply of foreign currency, the central bank will buy foreign currency using its domestic currency. This increases the supply of the domestic currency, pushing its value back down to the peg.
- In extreme cases, if the central bank cannot maintain the peg, it might be forced to officially devalue its currency (lower the fixed rate) or revalue it (raise the fixed rate).
Advantages:
- Stability and Certainty: Businesses engaged in international trade and investment face less exchange rate risk, making planning easier and potentially boosting trade and foreign investment.
- Inflation Control: By pegging to a stable foreign currency, a country can "import" the monetary discipline of the anchor country, helping to control domestic inflation.
- Reduced Speculation: In theory, a credible fixed rate can reduce speculative attacks, though this is not always true in practice.
Disadvantages:
- Loss of Monetary Policy Independence: To maintain the peg, the central bank must use its monetary policy tools (like interest rates) to influence capital flows and domestic money supply, often sacrificing the ability to use these tools for domestic goals like controlling inflation or stimulating growth.
- Need for Large Reserves: The central bank must hold substantial foreign exchange reserves to intervene in the market, which can be costly.
- Vulnerability to Speculative Attacks: If market participants believe the central bank cannot sustain the peg, massive speculative selling of the domestic currency can occur, forcing a devaluation.
- Potential for Misalignment: The fixed rate might become overvalued or undervalued relative to its equilibrium level, leading to persistent trade imbalances.
Flexible Exchange Rate System
In a flexible (or floating) exchange rate system, the value of a country's currency is determined purely by the forces of demand and supply in the foreign exchange market, without direct intervention from the government or central bank. The exchange rate is allowed to fluctuate freely in response to economic conditions, capital flows, and market sentiment.
Mechanism:
The exchange rate acts as the price of one currency in terms of another.
- If there is an increased demand for a country's goods, services, or assets (e.g., foreign investors want to buy domestic stocks), the demand for its currency rises. This causes the domestic currency to appreciate (its value increases).
- Conversely, if there is an increased supply of a country's currency (e.g., domestic residents want to buy more foreign goods or invest abroad), the supply of its currency rises. This causes the domestic currency to depreciate (its value decreases).
- The market automatically adjusts to clear any imbalances between demand and supply, with the exchange rate moving up or down until equilibrium is restored.
Advantages:
- Monetary Policy Independence: The central bank is free to use its monetary policy tools to achieve domestic objectives like price stability, full employment, or economic growth, without being constrained by the need to maintain an exchange rate peg.
- Automatic Adjustment to Shocks: The exchange rate acts as an automatic stabilizer. For example, if a country faces a trade deficit, its currency will depreciate, making its exports cheaper and imports more expensive, thus helping to correct the deficit.
- No Need for Large Reserves: Since the central bank does not intervene to maintain a specific rate, it does not need to hold large foreign exchange reserves for this purpose.
Disadvantages: …
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