FOREIGN EXCHANGE 8, FIXED AND FLEXIBLE EXCH, Broadly speaking, there c. , an be two fi types of ‘ red exchange rate system; and ome rate systems : . Fixed Exchange rate system. Fixed exchan lexible exchange rate system. between two or more countri ge rate g i ies does not vary or Varies eee Js a system where the rate of exchange IANGE RATES - free exchange rate on system, equilibrium level in the exchange neta 2, in terms of another is free nae oomaie exchange rate system, the rate of exch rough the forces of demand and supply. Under th Flexible government ; itis a system of chong wee, alowed to vary to suit the economic aa the forces of demand and suppl aie key to the lock. The flexible exchange rates are eerie be selling of the foreign currencies by ie ectanes market There are no restrictions on the buying wl scoring tothe anges nthe mand and sop of a ane ae ete ng Arguments for Fixed Exchange Rates The main arguments ad‘ i 7 ene rg) advanced in favour of the system of fixed or stable exchange rates are 1. Promotes International Trade. Fixed or stable exchange rates ensi i foreign payments and inspire confidence among the importers and exporters, Ths helps to promote en payments P , the importers and exporters. This helps to promote 2. Necessary for Small Nations. Fixed exchange rates are all the more essential for the smaller nations like the U.K., Denmark, Belgium, in whose economies foreign trade plays a dominant role. Fluctuating exchange rates will seriously affect the process of economic growth in these economies. 3. Promotes International Investment. Fixed exchange rates promote international investmen If the exchange rates are fluctuating, the lenders and investors will not be prepared to lend for long- term investments. 4 Removes Speculation. Fixed international transactions. There is no possibi in the system of fixed exchange rates. _ 5. Necessary for Small Nations. nations like the U.K., Denmark, Belgium, Fluctuating exchange rates will seriously disturb the p 6. Necessary for Developing Countries. Fixed exchanges rates are necessary and de developing countries for carrying out planned development efforts. Fluctuating rate sign capital. Process of economic development and restrict the inflow of foreign cap . ved or stable exchange rate system is 10s 7. Suitable for Currency Area. A fi 4 he countris of cumeney aren sacha ie string are 1 NE hy ke Egan HE , ctuations e lead " Currency area are flexible, the fluctuations in " i the whole area dom jt “change rates O nat > exchange rates 5), will also disturb the exchange rates A Aas in exchange rates eliminate, the speculative activities in the ility of panic flight of capital form one country to another all the more essential for the smaller ‘a dominant role. economies. xed exchange rates are in whose economies foreign trade plays rrocess of economic growth of these s are necessary and desirable for the b the smooth t suitable to a world ies in the common rency + stabilisation al economic stabil at hange f flexible 8. Economic Stabilisation. Fixed foreign © veonomy. Itt a system ol a anc oe the prices within the econ’ va syste fll gains from hacks unwarranted changes 9 Ue PEE tape wl Hk 1 coy s high because ‘and hoarding act rates, the licns is t ce liquidity preference ge ends to incre he fluctuating exchange rates: marae te vase priceMONEY BANKING AND INTERNATIONAL TRAD: i i the exchange rate does no, -manently Fixed. Under the fixed exchange rate system, n 7 remain peaoe is permanently frozen. Rather the rate is changed at the appropriate time to correct th, fundamental disequilibrium in the balance of payments. , saat 10. Other Arguments. Besides, the fixed exchange rate system is also beneficial on account oft, | I reasons. ; ; ® ne It ensures orderly growth of world’s money and capital markets and regularises the international capital movements. ; (ii) It ensures smooth functioning of the international monetary system. That is why, IMF has adopted pegged or fixed exchange rate system. ; ; (ii Te encourages multilateral trade through regional cooperation of different countries. (iv) In modern times when economic transactions and relations among nations have become too vast and complex, it is more useful to follow a fixed exchange rate system. Arguments against Fixed Exchange Rates The system of fixed exchange rates has been criticised on the following grounds : 1, Outmoded System. Fixed exchange rate system worked successfully under the favourable conditions of gold standard during 19th century when (a) the countries permitted the balance of payments to influence the domestic economic policy ; (b) there was coordination of monetary policies of the trading countries ; (c) the central banks primarily aimed at maintaining the external value of the currency in their respective countries ; and (d) the prices were more flexible. Since all these conditions are absent today, the smooth functioning of the fixed exchange rate system is not possible. 2. Discourage Foreign Investment. Fixed exchange rates are not permanently fixed or rigid. Therefore, such a system discourages long-term foreign investment which is considered available under the really fixed exchange rate system. 3. Monetary Dependence. Under the fixed exchange rate system, a country is deprived of it monetary independence. It requires a country to pursue a policy of monetary expansion or contracti in order to maintain stability in its rate of exchange. 4. Cost-Price Relationship not Reflected. The fixed exchange rate system does not reflect the true cost-price relationship between the currencies of the countries. No two countries follow the same economic policies. Therefore the cost-price relationship between them go on changing. If the exchang rate is to reflect the changing cost-price relationship between the countries, it must be flexible. 5. Not a Genuinly Fixed System. The system of fixed exchange rates provides neither the expectation of permanently stable rates as found in the gold standard system, nor the continuous and sensitive adjustment of a freely fluctuating exchange rate. 6. Difficulties of IMF System. The system of fixed or pegged exchange rates, as foll International Monetary Fund (IMB), is in eality a system oreanapad flexibility Tinvolves cota difficulties, such as deciding as to (a) when to change the external value of the currency; (b) what should be acceptable criteria for devaluation; and (c) how much devaluation is needed to reestobhet equilibrium in the balance of payments of the devaluing country. Arguments for Flexible Exchange Rates Flexible exchange rate system is claimed to have the following advantages : ind itdependent Monetary Policy, Under flexible ex an independent policy to conduct properly the domestic economic affairs. licy of @ countzy is not limited or affected by the economic conditions of other Seemed poy 2. Shock Absorber. A fluctuating exchange rate system protects i A ate s the domesti the shocks produced bythe disturbances generated i oer ee Teese econo frm and saves the internal economy from the disturbing effects from abroad. 3. Promotes Economic Development. The flexible exchai development and helps to achieve full employment in the count ‘change rate system, a country is free to adopt Inge rate system promotes economic The exchange rates can be changed in accordance with the requirements of the monetary policy of the country to achieve the p national objectives. lannedIS Ii roreIGN EXCHANGE 4, Solutions to Balance £ Pay the disequilibrium in eet Poble ms, in the balane The system of remov iments, the external value of a country'c of payments. When, z S. try’s currency \ there is deficit in the bal lance of pay ts are discouraged tl ged thereby, establishing anno) falls. A 8 equilibri S a result, exports are e ncouraged, and 9 flexib le exchange rates automatically impor changes in exchange rate: 8. pesaae ea Possibility of scarcity or surplus of t - i, lus 0 5 promotes international trade is not omoted by Fixed Rates. The ar a arr feces the other hand under the flexible nt stpported by historical facts fone that fixed exchange rates assessed through the forword market, ange rate system, the trend ofthe rate of chanee sercyally eater cree rae TFS al - and the traders are protected pera on octange i generally ant 9. International Investment ere aoa Eee eee a international investments ar romoted’ by! Eixed Bat Starets ; tes. Th lenders and borrowers cannot Seer rea fixed exchange rate Beata cane lone erm 10. Fixed Rates not N change 2189 ty norseies alable aver aa lecessary for ¢ a very long period. et bata rates of the member countries. Ee EE EOE . Speculation not Prevented by Fixed Rat 1 0 " ites. ae is that in spite of the strict exchange control ¢ the stability in the exchange value of the home cu : le. For instance, the pound had to be devalu rguments against Flexible Exchange Rates The following are the main drawbacks of the system’ of flexible exchange rates : ae Low Elasticities. The elasticities in tional markets are too low for exchange rate ore to operate successfully in bringing librating adjustments, When import Feaceint elasticities are very low the exchange nt table, Hence, the depreciation of e weak currency would simply tend to worsen the ‘balance of payments deficit further. 2. Unstable Conditions. Flexible exchange rates create conditions of instability and uncertainty which, in turn, tend to reduce the volume ‘of international trade ‘and foreign investment. Long; foreign investments are greatly reduced becaus® ‘of higher risks involved. f flexible exchange rates 3. Adverse Ef wre structure. The syste) 0 of the economy Uestabilise the economy o ‘The main weakness of the stable ness exchange ra ‘urrency speculation is encouraged. This okays rrency and makes devaluation of the currency ‘ed in 1949 mainly because of such speculation. the internat about automatic equil arket becomes uns! has serious go unecessary Tepercussion on the econom the price of imported and exported jgoods which, in Wann, Cay __ 4.Unnecessary Capital Movements. The system of fluctuating Fe hange fa ea pune eee er Umeesany Cail ery naar te ee ty scale capital outflows and inflows, thus, serious! ye eculative capital movements caus by ftuctating ital Movements: SP, jiquility preferen faSjuation of High emely ne rvestment falls and there is e 5. Depression Effects of Cap’ Fextn xchange rates may lead to the Baa a oeency: interest rates TSE, liquidity preference, Peo) large-scale unemployment in the economy:ll _ MONEY BANKING AND INTERNATIONAL Tray, involves greater possibility of inflatio, i Dole exchange rate system invol 1 ity of in eal fatonay Ee Jon on domestic juice level of a country. Inflationary rise in prices effec ot depreciation of the external value of the eurrencY™ 7, Facto Immability. The immobility of various factors © 8 its adv ing from the adop' yy ar sate spt of 8 aan ae sable fits on production and employment only wy) ¥ factors of production is elastic. ; suPPY or re of Fleuble Rate System, Hxperience of the flexible exchange mls system ada between the two world wars has shown that it. was a flop. Conclusion ; Tis a debatable question whether a country should adopt a fixed oe Slecble exchange rae Both the types of exchange rate system have their relative merits and demerits. Actual ex porn vcr, bidicates that the success or appropriateness of an exchange rate system! Sepends upon sow economic conditions of the country and the external shocks. (1) if the world economy itself Tlable and there are no fluctuations in the trend rate of exchange, the fixed exchange rate system Tikely to be quite successful. (b) If the world conditions are chaotic and the internal economy of Country relaively stable, the flexible exchange rate system will work smoothly and have little dist Sffects. (c) If, on the other hand the economy is relatively unstable and is more open to exte fluctuations due to greater dependence on foreign trade, flexible exchange rate system will hz destabilising effects. 9. DEBATE OVER FIXED AND FLEXIBLE EXCHANGE RATES Theoretical Debate ‘Though the debate still continues over the relative merits of (a) fixed or stable exchange rates i flexible or floating exchange rates, and (c) a compromise between the two systems, it is not compl unresolved. Both theory and experience, however, have combined to resolve partly some of the ke} issues in the debate. These key issues are : (a) the argument of price discipline; () the risk argument ; and (© the argument of destablising speculation. __ 1. Argument of price Discipline. One major argument adv. i i an against fetble exchange rates is thatthe fled exchange rates weaken enteral pace aecpline allow more inflation. The argument runs as follows : The fixed exchange rate system puts more press on the deficit countries to deflate more than on the surplus countries to inflate. Thus, allowing th governments to switch over to flexible exchange rates system will on the average release more inflation] policies. This argument is correct and is s cl ion i polices: This argu | tand is supported by the fact that world inflation increased aftet syst But, whether one considers this a i scons s'gument for fixed or flexible ex. It depends ttpon one’s view of unemployment-inflation dilemma. Those who care much about fi iploym are not much bothered about price inflation might prefer flexible rates because flexible rates enhance the ability of deficit ies j caniraty, those who fear inflation alone all are more italy fe eee cugh expansionary polis O° ' u likely to favour fixed exchange rates. nae isk Argument. The argument that flexible exchange rates expose ie and investors f q fe. he arguments needed to defend fixed exchange rates against the sho that are experienced in any other system of e) es are li change essen eect aly mae gre cana Ha bles ety Unde te market. On the other hand, it is much harder to i ange rate risk through hedging in the forw’ resulting from the atiempts to defend fixed exchange agaiot a sudden oss of job or sudden infati! 3. Argument of Destabilising Speculatio ; : destabilising speculation is not fully supported by ge argument that flexible exchange rates bret change rates involve value judge)FOREIGN EXCHANGE xchange fates may be stabilisi e (e.g, fall i ising or des wot rete (eg, fall in dollar per pound) apiSiNg. If the s of foreign exchange when itis below th when it abn BeCuatOrs expect fall ioe eee ane ug end level, they the trend level, and fallin the price of foreign culation. id buy it , they |, and expect a rise i : spect Sund) wher oe hand, if the eee its price is : sell the foreign pe a tise in the price (eg P' hen it is above the trend ulators expect elow trend. ‘This is cel (pound) when ( ound) when it is below the trend le level and Boars further rise in the is is called stabilising is above trend and sell it when its ne they tend to bur re ther fall in the Price of foreign currency ‘According to Friedman, the eee is below trend. Thi foreign currency Goma currency : a case of destabilising speculates. \g speculation. speculators will be losing m« abilising 5 : ‘oney by buying Reena is self-eliminatin, selling low over cad pana destabilising of exchange rate movement and will go bankru; a ipt if the 6 under afloxble exchange rate eine continue behaving in thi merely a theoretical question, but also speculation will i is manner. But, the questi actual facts. Such a study will bri also an empirical questi reality be stabilising, or destebilidive og ae about losing money and act ey 5, ston, and bas to be anewered bp detector a eerie lost money, but produced eet vlators didnot iistovcally the sucess or fi lorical Experience ising effects. severity of shocks with which these eyeten tess enanse fate system Af ctialsienatea ees avs es had to deal. ystems has depended upon the successfully before 1914 because the world « fixed exchange rate system period, even fluctuating exchange orld economy itself was eae aa > Inter-War Period of Ins sara regimes showed stability. stable. During this stable pre-war vihole wotld were chaotic Fixed rates broke doe acl oot Shan aom Epil stan Berens ata nig ‘owed signs of stabilising ave shown thatthe interwar pvr the fedble testes we speculatic t h inter-war period, stability and of destabilising eecoation a ae countries with conditions of ‘ave mae eee atte 3, Adjustable Peg System (1944-1971) eee eee conor economy, internati 14-1971). In the more stable zi i called the Berea wou aaa institutions proved more See fa The ternational nana es Seni ee provided a modified gold exchange standard. Under these aps gold for lle with foreign central banks a ee ee eerie emai exchanging ind (IME) wes toured as alpatt of sata Bed Pr table pes sytem Monetary compromise between fixed and flexible exch system. The agustable peg ystom provided eh > ” "xchange rate systems and was aimed at achieving the twin aa i ) ie establish international harmony and stable ‘exchange rates associated with the gold 1; anc . * a a e ar and) allow Fine mantis te freedom to pursue thei own macroeconomic pollies. . Collapse of Adjustable Peg System. The post-war experience with adjustable pegged exchange hesystem ceased she ‘owed that there were rare changes in exchange rates inherent in the system. itself. It carried within itself the seeds of (a) stable exchange ns be due to the basic flaws destruction. The contradictory features of the adjustable peg system were : economic policies ; and (c) extensive international capital movements ternational transactions. The fe and liberalisation of in deperure and cid not like to impose conteels Tins, the first feature must go: Ultimately, the placed by the system of ‘managed floating, rates the system of managed floating rates as been a ;(b) autonomous national macro* asa result of steady growth of international trad necesss were unwilling to dispense with the secon adjus BB to nullify the effects of the third feature. ‘ a peg system collapsed in 1971 and was 10 . Managed Floating Rates (after 1971). 6 adopted by most of the ng ntries of the world. Under this system, the currency of county alowed oat i 5 ol Fld oeits exchange rate accorling 1 market forces. Floa on foreign exchange marke an i its exchange rate Meretary authorities may intervene rate does not imply complete absence ‘of official intervention. The to restrict the fiyctuations in the exchange rate invthan certain Fits: In order to avoid disorderly fluctuations, in the 6. Rules for Managed Floating. i oa and all i 2 ion i ‘ordance with some international guidelines, Ver" exchange rates us formal ject. The