Fixed Vs Flexible Exchange Rates

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 almost stable. During post-war II period, the IMF had brought a new phase of exchange rate stability. Most governments have maintained adjustable fixed exchange rate till 1973. But the IMF system failed to provide an adequate solution to three major problems causing exchange instability, viz., (i) providing sufficient reserves to mitigate the short-term fluctuations in the balance of payments while maintaining the fixed exchange rates system; (ii) problems of long-term adjustments in the balance of payments; and (iii) crisis 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.  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 rates may change over time as priorities change. 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.

• Fixed rates provide stability in international prices for the conduct of trade.
• Fixed exchange rates are anti-inflationary, requiring the country to follow fiscal policies and restrictive monetary policies.
• An international or foreign currency markets have grown rapidly in volume and size, increasing reserve holdings has become a significant burden to many nations.
• Fixed rates, once in place, can be maintained at rates that are inconsistent with economic fundamentals. 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.