International Economics >> Fixed Exchange Rate, Flexible Exchange Rate
The Exchange Rate Policy Fixed vs Flexible Exchange Rate
Market determined exchange rate is a freely flexible rate. H keeps changing following the change in the demand for and supply of foreign exchange. Flexible exchange rate has however certain serious disadvantages. The most serious disadvantage of flexible exchange rate is that it causes instability in trade, foreign investment, production and employment. Therefore, a section of economists has argued for adopting a fixed exchange rate system. In fact, fixed exchange rate system has been a common practice in pre- War I period. Prior to the first World War, almost all countries were on the fixed exchange rate system. The reason was, all major countries were on the gold standard; the ex-' change rate between any two currencies was determined on the basis of 'mint parity of gold' of the currencies; gold price was stable; and therefore the exchange rate was fixed. The IMF works for a fixed exchange rate policy for its member nations with some provision for flexibility in the exchange rate. However, the experience has shown, as we will discuss later, that fixed exchange rate policy is not consistent with the rapidly changing world. Even the fixed or controlled exchange rate has to be changed frequently. Some economists, most notably Milton Friedman, has argued strongly for market determined flexible exchange rate. Whether fixed and flexible exchange rate has been a controversial issue. The debate on this issue is still inconclusive, despite IMF supporting the fixed and stable exchange rate. In this chapter, we will discuss briefly the arguments for and against the fixed and flexible exchange rate. We will finally present a brief description of the present exchange rate regime.
The fixed exchange rate
In contrast to freely fluctuating market determined exchange rate, fixed exchange rate is one that is determined by the monetary authorities from time to time for all international transactions. Flexibility in exchange rate is, however, allowed within the limits prescribed by the IMF, usually one per cent up and down under normal conditions. Under the fixed exchange rate regime, the monetary authority of a country, generally its central bank, fixes an official price of its currency in terms of a reserve currency (the US dollar) or a basket of key currencies. This rate is announced to the market through an official notification. The exchange rate so determined is known as currencies par value. It is also called 'fixed' or 'pegged' exchange rate. Under the fixed exchange rate system, the government undertakes to buy and sell the foreign currency through the authorized banks and dealers. Private sale and purchase of currency are suspended. Change in the fixed exchange rate is done by the government within the limits suggested by the IMF. However, most countries adopt a dual system-fixed exchange rate for all official transaction and market rate for private transactions.
Fixed vs. Flexible exchange rate
Exchange rate stability has always been the objective of monetary policy of almost all countries. Except during the period of the Great Depression and World War II, the exchange rates have been fairly stable. During the post-War II period, the IMF brought a new phase of exchange rate stability. Most governments had maintained adjustable fixed exchange rate till 1973. Thereafter, however, the IMF system failed to provide an adequate solution to three major problems:
(i) providing sufficient reserves to mitigate the short-term fluctuations in the balance of payments while maintaining the fixed exchange rate system; (ii) problems of long-term adjustments in the balance of payments; and (iii) crises generated by speculative transactions.
As a result, the currencies of many countries, especially the reserve currencies, were subject to frequent devaluation in the early 1970s. This caused exchange instability which raised doubts about the continuation of the Bretten Wood System and also about the viability of the fixed exchange rate system. The breakdown of Bretten Wood system generated a debate on whether a fixed or flexible exchange rate system is desirable for the world economy.
It may be noted here that arguments for fixed exchange rate are the arguments against the flexible exchange rate and the arguments for flexible exchange rate make the arguments against the fixed exchange rate. We' will therefore, present only the arguments for the fixed and the flexible exchange rates. The main arguments given in favour of fixed and flexible exchange rates are as follows.
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