Question

State arguments for and against flexible rate of exchange.

Answer 1

A Flexible Exchange Rate (also called a floating exchange rate) is determined by the free forces of demand and supply in the foreign exchange market, without government intervention. This system has both advantages and disadvantages.

1. Arguments for a flexible rate of exchange:

1. Automatic Adjustment of BoP Disequilibrium: Exchange rates adjust automatically based on trade flows, helping to correct balance of payments deficits or surpluses.
2. No Need for Foreign Exchange Reserves: Since the central bank doesn't need to intervene constantly, there is less pressure to maintain large foreign exchange reserves.
3. Freedom in Monetary Policy: The central bank can focus on domestic objectives like inflation control and growth, without worrying about maintaining a fixed rate.
4. Encourages Market Efficiency: Currency value reflects real economic strength, as it is determined by market forces.

2. Arguments Against Flexible Exchange Rate:

1. Exchange Rate Volatility: Constant fluctuations can lead to uncertainty in international trade and investment, discouraging long-term commitments.
2. Speculative Attacks: Flexible systems are more prone to speculation, which can cause sudden and sharp currency movements.
3. Imported Inflation: If the domestic currency depreciates, the cost of imports rises, leading to inflation in the economy.
4. Adverse Impact on Developing Countries: Many developing countries lack robust financial systems and may experience instability and capital flight under a floating exchange rate regime.