What are the main advantages and the drawbacks of operating with a fully fixed exchange rate? (2024)

FAQs

What are the main advantages and the drawbacks of operating with a fully fixed exchange rate? ›

This can protect a nation's economic interests and give its exported goods the comparative advantage of a lower price. The practice has disadvantages, including a requirement for maintaining large capital reserves and a potential vulnerability to inflation.

The advantages of a fixed exchange rate include:

Providing greater certainty for importers and exporters, therefore encouraging more international trade and investment. Helping the government maintain low inflation, which can have positive long-term effects such as keeping down interest rates.

Fixed exchange rates reduce foreign exchange risk for companies with cross border trade. The major disadvantage of fixed exchange rate system is that it establishes a direct link between domestic and foreign inflation and employment.

Lack of Flexibility: One of the main drawbacks of a fully fixed exchange rate system is the lack of flexibility in responding to external economic shocks. Countries cannot independently adjust their exchange rates to address changing economic conditions.

Drawbacks of Free-Floating Exchange Rates:

Currency Risk: The volatility of exchange rates introduces currency risk for businesses and investors. Inflation Pass-Through: Exchange rate fluctuations can lead to changes in import prices, which can impact domestic inflation.

An advantage of a fixed exchange rate system is that governments are not required to constantly intervene in the foreign exchange market to maintain exchange rates within specified boundaries.

Fixed exchange rates work well for growing economies that do not have a stable monetary policy. Fixed exchange rates help bring stability to a country's economy and attract foreign investment. Floating exchange rates work better for countries that already have a stable and effective monetary policy.

The cost of production for firms will rise, leading to a raise prices for the final products. To sum up, a high exchange rate may be a good fight against inflation, but unemployment could be created, whereas a low value of a currency may be good for solving unemployment problems, but may create inflationary pressure.

A fixed exchange rate can be expensive to maintain. A country must have enough foreign exchange reserves to manage its currency's value. A fixed exchange rate can make a country's currency a target for speculators. They can short the currency, artificially driving its value down.

What are the advantages of fixed exchange rates and floating exchange rates? ›

Import inflation protected

Countries with fixed exchange rates face the problem of importing inflation through surpluses of the balance of payments or higher prices of imports. However, countries with floating exchange rates do not face such a problem.

Using a floating currency can be considered a fiscal benefit when the economy is strong and fiscal policy is sound. But, if market sentiment towards the government and its monetary policy is weakened, it could lead to a devaluation of its currency.

Advantages and Disadvantages of Competitive Devaluation

Because it makes imports more expensive, currency devaluation can positively impact a nation's trade deficit. Currency devaluation forces domestic consumers to look for local alternatives to imported products, which then provides a boost to the domestic industry.

Fixed Exchange Rates: An exchange rate system where exchange rates are fixed by the central bank of each country. Floating Exchange Rates: An exchange rate system where exchange rates are determined entirely by market forces.

Fixed Exchange Rates offer stability at the cost of substantial reserves, while Flexible Exchange Rates allow market-driven adjustments with potential volatility. Managed Floating serves as a middle ground, permitting central bank interventions to moderate extreme rate fluctuations.

A flexible exchange rate system provides the government with more flexibility, and it does not need to perpetuate large stocks of foreign exchange reserves. The vital merit of flexible exchange rates is that movements in the exchange rate instinctively takes care of the deficits and surpluses in the balance of payment.

Pegged regimes are associated with lower inflation, lower nominal and real exchange rate volatility, and greater trade openness—all of which are associated with faster growth.