Flexible Exchange Rate System
Exchange rate systems are classified according to the degree to which the rates are controlled by the government. They fall into the following categories: Fixed, Flexible, Managed float and Pegged (Steinberg & Malhotra, 2014). In this case, focus is on the flexible and fixed exchange rate systems.
Flexible exchangerate refers to the exchange rates that are freely determined by the market forces i.e. the forces of demand and supply. The advantages of flexible exchange rates are:
- Individual country is insulated against the economic problems of the other countries. Therefore the problem such inflation, unemployment of one country does not affect the operations of the country.
- Under this exchange rate, the central bank interventions are not needed that may affect the economy unfavourably.
- Third, the government are not restricted to the exchange rate boundaries when setting new boundaries.
- Finally, less capital flow restrictions and therefore this enhances the efficiency of the financial market.
The disadvantages include:
- The MNCs may need to devote substantial resources in managing exposure to exchange rate fluctuations.
- The country that experiences the economic problem may compound the problems more.
Fixed Exchange Rate System
Fixed exchange rate systems are held constant or allowed to fluctuate only within very narrow bands. They came into existence during the Breton wood era (1944-1971) that fixed the exchange rates in terms of gold. Around 1971, the Smithsonian agreement that followed merely adjusted the exchange rates and expanded the fluctuation boundaries. The advantages of the fixed exchange rate systems are that it makes it easier the work of the multinational corporations(Williamson, 2014). However, the disadvantages of this system are that government may revalue their currencies. In fact, the dollar had been revalued more than once when the US experience balance of trade deficit. Second, each country becomes vulnerable to the economic conditions in other countries. Example for a fixed exchange rate system is that US dollar was linked to gold in around 20th century. This was referred to as gold standard.
Indeed, there are 116 separate cases where the exchange rate fell more than 25 per cent within the year between 1975 and 1996. Most of these were under the flexible regimes. In 1973, there were changes in the pattern of the world trade and world economics due to OPEC oil shock. Therefore, fixed exchange rate would have caused major problems (Edwards, 2015).
Edwards, S. (2015). Monetary Policy Independence under Flexible Exchange Rates: An Illusion.The World Economy.
Steinberg, D. A., &Malhotra, K. (2014). The Effect of Authoritarian Regime Type on Exchange Rate Policy.World Politics, 66(03), 491-529.
Williamson, J. (2014). The future exchange rate regime.PSL Quarterly Review, 28(113).