An exchange rate is simply the price of one currency in terms of another. The process by which that price is determined depends on the particular exchange rate mechanism adopted. In a floating rate system, the exchange rate is determined directly by market forces, and is liable to fluctuate continually, as dictated by changing market conditions. In a ‘fixed’, or managed rate system, the authorities attempt to regulate the exchange rate at some level that they consider appropriate. Such a system often seems appealing to those who are troubled by the uncertainties of the present, highly volatile, floating rate environment.
But the choice of exchange rate regime involves considerations that extend beyond the stability or otherwise of currency prices.
Exchange rates stability has always been the objective of monetary policy of almost all countries. Except during the period of great depression and world war II , the exchange rate have been almost stable. During the post- war II period , the IMF had brought a new phase of exchange rate stability.
Most governments have maintained adjustable fixed exchange rates till 1973. But the IMF system failed to provide an adequate solution to three major problems causing exchange instability-
- Providing sufficient reserves to mitigate the short term fluctuations in the balance of payments while maintaining the fixed exchange arte system.
- Problems of long term adjustments in the balance of payments.
- Prices generated by speculative transactions.
For these reasons the currencies of many countries , especially the reserve currency were subject to frequent devaluation in the early 1970,s. this raised doubts about the possibility of the Brettenwood,s system,and also about the viability of the fixed exchange rate system. The breakdown of Brettonwood system generated a debate on whether fixed or flexible exchange rate should be used.
The main arguments in favour of fixed exchange rates are:
- Firstly,Fixed exchange rate provides stability in the foreign exchange market and certainty about the future course of the exchange rate and it eliminates risks caused by uncertainty due to fluctuations in the exchange rates. 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 international trade. As a result foreign trade oriented economies become subject to severe economic fluctuations, if import elasticities are less than export elasticities.
- Secondly , the fixed exchange rate system creates conditions for smooth flow of international capital simply because it ensures a certain return on the foreign investment. While in the case of flexible exchange rate, capital flows are constrained because of uncertainity about expected rate of return.
- Thirdly, the fixed rate eliminates the possibility of speculation, whereby it removes the dangers of speculative activities in the foreign exchange market. On the contrary flexible exchange rates encourage speculation.
- Fourthly , the fixed exchange rate system reduces the possibility of competitive depreciation of currencies as it happened during 1930s. also, deviations from fixed rate are easily adjustable.
- Fifthly, a case is also made in favour of fixed exchange rate on the basis of existence of currency areas. The flexible exchange rate is said to be unsuitable between the nations which constitute a currency area, since it leads to a chaotic situation and hence hampers trade between them.
The main arguments in favour of flexible exchange rates are:
- Firstly, flexible exchange rate system provides larger degree of autonomy in respect of domestic economic policies as it is not obligatory for the coutries to tune their domestic policies to fixed foreign exchange rate.
- Secondly, flexible exchange rate is self adjusting and therefore it does not devolve on the government to maintain an adequate foreign exchange reserve.
- Thirdly, the flexible exchange rate, which is determined by market forces, has a theory behind it and has the quality of predictability.
- Fourthly, flexible exchange rates serve as a barometer of the actual purchasing power and strength of a currency in the foreign exchange market. It serves as a useful parameter in the formulation of the domestic economic policies.
- Fifthly, economists have also argued that the most serious charge against fluctuating exchange rate i.e. unceratinty is not tenable because speculators themselves create conditions for exchange rate stability. Also, the degree of uncertainity associated with flexible exchange rate could not be much greater then what the world has experienced with adjustable fixed exchange rate under the brettonwood’s system.