Merits and Demerits of Fixed Exchange Rate System

Fixed exchange rate system was abandoned in 1977. !twas replaced by a flexible s
exchange rate. Let us understand the merits and clements of fixed exchange rate syste;steill of
we take up details of the flexible exchange rate system. 'before
Merits
Fixed exchange rate system had the following merits or advantages:
(i) Stability: It ensures stability, in the international . money market/exchange rn
Day-to-day fluctuations are avoided. It helps formulation of long-term econom· a~ke1,
. .
particularly relating to exports and imports. Cies,
(ii) Encourages International Trade: Fixed exchange rate system implies low risk
uncertainty of future payments. It encourages international trade. and low
(iii) Coordination of Macroeconomic Policies: Fixed exchange rate helps coord· .
· · f th Id inauon 0f
macroeconomic policies across different countries o e wor . Long-term econorni ..
can be drawn in the area of i~ternational trade and bilateral trade agreements. c poliaei
b
Demerits
Principal demerits of fixed exchange rate system are as under:
(i) Huge International Reserves: Fixed exchange rate system is often supported with h
international reserves of gold. This is because different currencies are directly or indirJ'.
convertible into gold. I l
(ii) Restricted_Movem~nt of Capital: To mai_ntain fixed exchange rat~ requires the help of huge
amount of mternauonal reserves. It restricts the movement of capital across different parts of
the world. Accordingly, international growth process suffers.
(iii) Discourages Venture Capital: Fixed exchange rate .discourages venture capital in the
international money market. Venture capital is that capital which is invested in foreign
currency in international money market, in order to earn profit. International moner
market is therefore restricted largely to international payments relating to exports and
imports.
(iv) Rigidity in Resource Allocation: Fixed exchange rate is by and large a rigid exchange rate.
It imparts rigidity to the allocation of resources particularly in the area of internation~
trade.
Merits and Demerits of Flexible Exchange Rate System
Merits
following are th e principal merits or advantages of flexible exchange rate system :
(i) N _o N ~ed for ~nternational Reserves: Flexible exchange rate system is not to be supported
with mternatwnal reserves. Because member countries (in the flexible exchange rate
system) are no longer floating 'convertible' currencies.
(ii) Optimum Res~urce Alloc_ation: Flexible exchange ~ate sys tem enhances efficiency in
resource allocauon. Accordmgly, allocation of resources in the area of international trade,
tends to become optimum. 3

(iii) International Capital Movement: Flexible exchange rate system enhances movement of
capital across different countries of the world. This is due to the fact that member countries
are no longer required to keep huge international reserves.
(iv) Venture Capital: Flexible exchange rate promotes venture capital in the foreign exchange
market. Trading in international currencies itself becomes an important economic activity.
Demerits
But merits of flexible exchange rate system are not without its demerits. Following points may be
noted in this regard :
(i) Instability: It causes instability in the international money market. Exchange rate tends to
fluctuate like price of good in the commodity market.
(ii) Instability in International Trade: Instability in the foreign exchange market causes
instability in the area ofinternational trade. It becomes difficult to draw long-period policies
of exports and imports.
280 Introductory Macroeco
riorn;cs

(iii) Ma~no~c Policies: While fixed exchange rate helps . ~oordination of macroeconoIJtic j
policies, flexible exchange rate makes it a difficult .proposiuon . . Day-to-day fluctuation m
·
exch ange rate makes bilateral trade agreements a difficult exercise.