Fixed and Flexible Exchange Rate System

An exchange rate is the price at which one currency is converted into or exchanged for another currency.

Exchange rate connects the price system of two countries since this (special) price shows the relationship
between all domestic prices and all foreign prices.

Any change in the exchange rate between rupee and dollar will cause a change in the prices of all American
goods for Indians and the prices of all Indian goods for Americans. In the process, equilibrium in BOP
accounts will be restored.
Every government has to make international decisions of what type of exchange rate it wants to adopt. This
means that government will have to decide how its own currency should be related to other currencies of
the world.

For instance, it may choose to fix the value of its currency to other currencies of the world so as to adjust
its BOP difficulties or it: may choose to allow its currency to move freely against other currencies of the
world so as to adjust its BOP difficulties. This means that there are two important exchange rate systems
the fixed (or pegged) exchange rate and the flexible (or fluctuating or floating) exchange rate.

These two exchange rates have been tried and tested in the past. Fixed exchange rate system had been tried
by the IMF during 1947- 1971 when this system was abandoned. After 1971, the world’s exchange rate
became a flexible one or a floating one. Truly speaking, the exchange rate that is being followed by the
IMF now is known as ‘managed floating system, or ‘managed flexibility’.

(A) Fixed Exchange Rate:

A fixed exchange rate is an exchange rate that does not fluctuate or that changes within a pre-deter- mined
rate at infrequent intervals. Government or the central monetary authority intervenes in the foreign
exchange market so that exchange rates are kept fixed at a stable rate. The rate at which the currency is
fixed is called par value. This par value is allowed to move in a narrow range or ‘band’ of ± 1 per cent.

If the sum of current and capital account is negative, there occurs an excess supply of domestic currency in
world markets. The government then intervenes using official foreign exchange reserves to purchase
domestic currency.

The fixed or pegged exchange rate can be explained graphically. Let us suppose that India’s demand for
US goods rises. This increased demand for imports causes an increase in the supply of domestic currency,
rupee, in the exchange market to obtain US dollars. Let DD and SS be the demand and supply curves of
dollar in Fig. 5.7. These two curves intersect at point A and the corresponding exchange rate is Rs. 40 = $1.
Consequently, the supply curve shifts to S1S1 and cuts the demand curve DD at point B. This means a fall
in the exchange rate.
To prevent this exchange rate from falling, the Reserve Bank of India will now demand more rupee in
exchange for the US dollars. This will restrict the excess supply of rupee and there will be an upward
pressure in exchange rate. Demand curve will now shift to DD1. The end result is the restoration of the old
exchange rate at point C.

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Thus, it is clear that the maintenance of fixed exchange rate system requires that foreign exchange reserves
are sufficiently available. Whenever a country experiences inadequate foreign currency reserves it won’t
be able to purchase domestic currency in sufficient quantities. Under the circumstance, the country will
devalue its currency. Thus, devaluation means an official reduction in the value of one currency in terms of
another currency.
(B) Flexible Exchange Rate:
Under the flexible or floating exchange rate, the exchange rate is allowed to vary to international foreign
exchange market influences. Thus, government does not intervene. Rather, it is the market forces that
determine the exchange rate. In fact, automatic variations in exchange rates consequent upon a change in
market forces are the essence of freely fluctuating exchange rates.

A deficit in the BOP account means an excess supply of the domestic currency in the world markets. As
price declines, imbalances are removed. In other words, excess supply of domestic currency will
automatically cause a fall in the exchange rate and BOP balance will be restored.

Flexible exchange rate mechanism has been explained in Fig. 5.8 where DD and SS are demand and supply
curves. When Indians buy US goods, there arises supply of dollar and when US people buy Indian goods
there occurs demand for rupee. Initial exchange rate—Rs. 40 = $1—is determined by the intersection of
DD and SS curves in both the Figs. 5.8(a) and 5.8(b).

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An increase in demand for India’s exportables means an increase in the demand for Indian rupee.
Consequently, demand curve shifts to DD1and the new exchange rate rises to Rs. 50 = $1. At this new
exchange rate, dollar appreciates while rupee depreciates in value [Fig. 5.8(a)].
Fig. 5.8(b) shows that the initial exchange rate is Rs. 40 = $1. Supply curve shifts to SS 1 in response to an
increase in demand for US goods. SS1 curve intersects the demand curve DD at point B and exchange rate
drops to Rs. 30 = $1. This means that dollar depreciates while Indian rupee appreciates.
(C) Managed Exchange Rate:
Under the managed exchange rate, floating exchange rates are ‘managed’ partially. That is to say, exchange
rates are determined in the main by market forces, but central bank intervenes to stabilise fluctuations in
exchange rates so as to bring ‘orderly’ conditions in the market or to maintain the desired exchange rate
values.

BASIS FOR
FIXED EXCHANGE RATE FLEXIBLE EXCHANGE RATE
COMPARISON

Meaning Fixed exchange rate refers to a rate which Flexible exchange rate is a rate that
the government sets and maintains at the variate according to the market
same level. forces.

Determined by Government or central bank Demand and Supply forces

Changes in currency Devaluation and Revaluation Depreciation and Appreciation

price

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 Speculation Takes place when there is rumor about Very common
change in government policy.

Self-adjusting Operates through variation in supply of Operates to remove external

mechanism money, domestic interest rate and price. instability by change in forex rate.

Fixed Exchange Rate (Advantages and Disadvantages)

1. Advantages:
(i) 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 programmes 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 minimised largely, if exchange rates are not
allowed to vary.

(ii) Speculation Deterred:

As the 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 periods eliminates the threat of speculation, it
discourages 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.

(iii) 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.

(iv) Adoption of Responsible Macroeconomic Policies:

Stable exchange rate system prevents government from adopting irresponsible macroeconomic policies like
devaluation of currencies. Above all, under the fixed exchange rate system, deflationary policies can even
be pursued to tide over BOP deficit, even without bringing any change in domestic policies.

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(v) 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.

(vi) 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 fuels inflation. Such a situation can be prevented
by making the exchange rate fixed.

2. Disadvantages:
(i) Speculation Encouraged:
In fact, uncertainty and, hence, speculative activities, tend to get a boost even under the fixed rate system.
Under a fixed rate system, if a country faces huge BOP deficit then the possibility of speculation gets
brightened. If speculators 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 speculators will be encouraged to sell domestic currencies
in the foreign exchange market.

If such sell of home currencies continue 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. This will make these people to earn profit.
Bretton Woods system of the IMF collapsed in 1971 because of such speculation made with the US dollars.

(ii) Adequacy of Foreign Exchange Reserves:

For the effectiveness of 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.

(iii) Internal Objectives of Growth and Full Employment Sacrificed:

When countries experience large and persistent deficits or ‘fundamental disequilibrium’ in BOP, they are
down with 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.

Thus, fixed exchange rate in the ultimate analysis go for currency depreciation that results in lower
economic growth and higher unemployment coupled with high inflation—the two most undesirable and
unpleasant macroeconomic variables not liked by anyone.

(iv) International Competitive Environment Bypassed:

The continuous changes in international competitive environment do not get reflected under the fixed
exchange rate system. Thus, to make the home product more competitive in the foreign market, what is

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required is the change in domestic economic policies so that country’s export products get larger foothold
in the foreign market. In other words, fixed exchange rate system fails to gloss over the international
competitive environment.

This kind of exchange rate developed after the World War II. The International Monetary Fund set up by
the Bretton Woods Agreement of 1944 came into operation in March 1947. The period 1947-1971 came to
be known as ‘fixed but adjustable exchange rate system’ or ‘par value system’ or ‘pegged exchange rate
system’, or ‘Bretton Woods system.

As the Bretton Woods system collapsed this exchange rate was abandoned in 1971. Several stopgap
measures were taken but uncertainty and confusion in exchange rate system continued. Ultimately, in 1973,
the world’s exchange rate system came to be known as ‘managed floating’—in the sense that currencies
tend to float more or less freely in the foreign exchange market.

Flexible Exchange Rate (Advantages and Disadvantages)

I. Advantages:
(i) Automatic Adjustment in BOP:
The chief merit of the freely fluctuating exchange rate is that BOP disequilibrium gets corrected
automatically with the change in exchange rate.

If BOP deficit arises, there would be an excess supply of home currency leading to a fall in exchange rate
simply by the market forces of demand and supply. This causes export goods cheaper and import goods
dearer.

As a result, export tends to rise while imports tend to decline thereby removing deficit in the BOP account.
Similarly, supply in BOP account means excess demand for home currency and, thus, rise in the exchange
rate. This, in turn, encourages imports and discourages exports.

As a result, BOP accounts will reach equilibrium by the same logic. Thus, this exchange rate makes an
automatic adjustment in the BOP crises of an economy and that too without governmental intervention.

(ii) No Collusion between Internal-External Objectives:

Surplus and deficit in the BOP accounts get corrected if foreign exchange rate falls and rises, respectively.
In a regime of fixed exchange rate, removal of BOP deficit requires the adoption of internal policies like
fall in income and price level. In other words, pegged exchange rate requires a change in domestic
macroeconomic policies like deflationary policies of price and output reduction. But, under flexible
exchange rate system, a government can adopt independent monetary policy.

In other words, under this system of exchange rate, internal balance could be maintained by the government.
It is further argued that as it is a self-adjusting mechanism to restore BOP equilibrium, a government can
put more effort in tackling internal problems of inflation, unemployment, etc.

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In a flexible exchange rate, domestic economy remains insulated from external shocks and pressures. Under
this system, the threat of ‘importing inflation’ outside the country is minimum. In other words, price
feedback effect is imperceptible.

(iv) Minimum Buffer of Foreign Exchange Reserves:

Since exchange rate is not pegged under the floating arrangement of exchange rate, the central bank of a
country needs to hold adequate foreign exchange reserves as a buffer against unforeseen developments in
international trade.

II. Disadvantages:
(i) Uncertainty and Confusion:
Flexible exchange rate and trade presents an atmosphere of uncertainty and confusion and trade and
investment. Susceptibility to uncertainty is greater as soon as exchange rate fluctuates freely. Suppose, an
Indian has despatched an export ‘invoice’ to foreign buyers. But the Indian exporters do not know at what
price foreign currency will be converted into Indian currency. This kind of uncertainty hampers trade.
However, such uncertainty can be largely minimised through forward exchange contracts.

(ii) Hampering Investment:

Unregulated free-floating exchange rate often discourages foreign investment as exchange rate becomes
erratic and, hence, destabilising. Because of the uncertainty associated with this exchange rate involving
profit and loss implications of foreign investment deals, a country might experience decumulation of
capital. Hence destabilising in effect.

(iii) Risk, Instability and Speculation:

Flexible exchange rate encourages wide speculation since foreign exchange prices are not known in
advance as in fixed exchange rate. It is because of speculation there occurs disruptive hot money flows. To
put it elaborately, it can be argued that when the exchange rate tends to decline, speculators anticipate that
such would continue to decline further and the possibility of the flight of money to another country will
brighten. This will then cause a further fall in the exchange rate. Thus, greater the speculation against the
currency, the deeper the economic crises.

(iv) Inflationary in Character:

By nature, flexible exchange rate is inflationary. As soon as the exchange rate falls automatically
consequent upon BOP deficit, import goods become expensive. High cost of imported goods then fuel
inflationary tendencies.

It is because of these drawbacks of the freely fluctuating exchange rate that countries attach importance to
‘managed exchange rate’ with their central banks buying and selling currencies in the foreign exchange
market so as to moderate the degree of fluctuations as far as practicable.