Advantages of Fixed Exchange Rate System

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.

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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.

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. 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.
  7. 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.
  8. 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.
  9. 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.

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