Economics · Ch 6 — Open Economy Macroeconomics
Merits and Demerits of Flexible and Fixed Exchange Rate Systems
Merits and Demerits of Flexible and Fixed Exchange Rate Systems
The Core Tension: Credibility vs. Flexibility
The choice between a fixed and a flexible exchange rate system is not merely a technical one; it reflects a deeper trade-off between credibility and policy autonomy. A fixed rate promises stability but demands constant vigilance and large reserves. A flexible rate offers freedom but can be volatile. The textbook section examines the specific strengths and weaknesses of each.
Merits and Demerits of the Fixed Exchange Rate System
The Central Requirement: Credibility
The single most important feature of a fixed exchange rate system is that the government's commitment to defend the rate must be credible. The public and international financial markets must believe that the government has both the will and the means to keep the exchange rate at the announced level. If this belief is lost, the system begins to unravel.
The Problem of BoP Deficits and Reserve Intervention
When a country runs a Balance of Payments (BoP) deficit under a fixed rate, the demand for foreign currency exceeds its supply at the fixed price. To prevent the domestic currency from depreciating, the central bank must step in. It sells foreign currency from its official reserves (or foreign exchange reserves) to bridge the gap. This intervention is the government's primary tool to maintain the fixed rate.
A common mistake is to think that a fixed exchange rate is "automatic." It is not. It requires active, and often costly, intervention by the central bank whenever the market pressures push the rate away from the official peg.
The Danger of Speculative Attacks
The textbook highlights a critical weakness: if people believe the government's stock of foreign exchange reserves is inadequate to cover a persistent deficit, they will doubt the government's ability to maintain the fixed rate. This doubt triggers speculation that the currency will be devalued (the official rate is lowered).
This speculation can become a self-fulfilling prophecy. Traders and investors begin aggressively buying the foreign currency (or selling the domestic one) in anticipation of the devaluation. This massive selling pressure forces the government to either spend even more of its dwindling reserves or to capitulate and devalue. This forced devaluation, driven by speculative pressure, is called a speculative attack.
Fixed exchange rate systems are inherently prone to speculative attacks. The textbook explicitly cites the period before the collapse of the Bretton Woods System (the post-WWII global fixed-rate system) as a historical example of this vulnerability.
Merits and Demerits of the Flexible Exchange Rate System
The Key Advantage: Automatic Adjustment
The textbook presents the flexible (or floating) exchange rate system as a direct solution to the problems of the fixed system. Its primary merit is that movements in the exchange rate automatically take care of BoP surpluses and deficits.
- A BoP deficit (more demand for foreign currency) causes the domestic currency to depreciate (become cheaper).
- A cheaper domestic currency makes exports cheaper for foreigners and imports more expensive for residents.
- This, in turn, reduces the demand for imports and increases the demand for exports, eventually correcting the deficit.
- The opposite logic applies to a BoP surplus, causing an appreciation that corrects the surplus.
No government intervention is needed; the market price (the exchange rate) does the work.
The Key Advantage: Monetary Policy Independence …