A nation’s choice as to which currency regime to follow reflects national priorities about all factors of the economy, including inflation, unemployment, interest rate levels, trade balances, and economic growth. The choice between fixed and flexible exchange rates may change over time as priorities change.
At the risk of over-generalizing, the following points partly explain why countries pursue certain exchange rate regimes. They are based on the premise that, other things being equal, countries would prefer fixed exchanges rates.
- Fixed exchange rates provide stability in international prices for the conduct of trade. Stable prices aid in the growth of international trade lessens risks for all businesses.
- Fixed exchange rate system reduces the possibility of competitive depreciation of currencies, as it happened during the 1930s. Also, deviation from the fixed rates is easily adjustable.
- Fixed exchange rate provides stability in the foreign exchange markets and certainty about the future course of exchange rate and it eliminates risk caused by uncertainty. The stability of exchange rate encourages international trade. On the contrary, flexible exchange rate system causes uncertainty and might also often lead to violent fluctuations in the international trade. As a result the foreign trade oriented economies become subject to severe economic fluctuations, if import-elasticity is less than export elasticity.
- Fixed exchange rates are inherently anti-inflationary, requiring the country to follow restrictive monetary and fiscal policies. This restrictiveness, however, can often be a burden to a country wishing to pursue policies that alleviate continuing internal economic problems, such as high unemployment or slow economic growth.
- Fixed exchange rate system creates conditions for smooth flow of international capital simply because it ensures continuity in a certain return on the foreign investment, while in case of flexible exchange rate; capital flows are constrained because of uncertainty about expected rate of return.
- Fixed rate eliminates the possibility of speculations, where by it removes the dangers of speculative activities in the foreign exchange market. On the contrary, flexible exchange rates encourage speculation. There is controversy about the destabilizing effect of speculation. But, if speculators buy a currency when it is strong and sell it when it is weak, speculation will be destabilizing.
- Fixed exchange rate regimes necessitate that central banks maintain large quantities of international reserves (hard currencies and gold) for use in the occasional defense of the fixed rate. An international currency markets have grown rapidly in size and volume, increasing reserve holdings has become a significant burden to many nations.
- Fixed rates, once in place, can be maintained at rates that are inconsistent with economic fundamentals. As the structure of a nation’s economy changes and its trade relationships and balances evolve, the exchange rate itself should change. Flexible exchange rates allow this to happen gradually and efficiently, but fixed rates must be changed administratively- usually too late, too highly publicized, and too large a one-time cost to the nation’s economic health.
- A case is also made in favor of fixed exchange rate of the basis of existence of currency area. The flexible exchange rate is said to be unsuitable between the nations which constitute currency area, since it leads to chaotic situation and hence hampers trade between them.