File Name: advantages and disadvantages of flexible exchange rate system .zip
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A fixed exchange rate , sometimes called a pegged exchange rate , is a type of exchange rate regime in which a currency 's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies , or another measure of value, such as gold. There are benefits and risks to using a fixed exchange rate system. A fixed exchange rate is typically used to stabilize the exchange rate of a currency by directly fixing its value in a predetermined ratio to a different, more stable, or more internationally prevalent currency or currencies to which the currency is pegged. In doing so, the exchange rate between the currency and its peg does not change based on market conditions, unlike in a floating flexible exchange regime. This makes trade and investments between the two currency areas easier and more predictable and is especially useful for small economies that borrow primarily in foreign currency and in which external trade forms a large part of their GDP.
Flexible exchange rate system is claimed to have the following advantages:. Under flexible exchange rate system, a country is free to adopt an independent policy to conduct properly the domestic economic affairs. The monetary policy of a country is not limited or affected by the economic conditions of other countries. A fluctuating exchange rate system protects the domestic economy from the shocks produced by the disturbances generated in other countries. Thus, it acts as a shock absorber and saves the internal economy from the disturbing effects from abroad.
Fixed exchange rate systems were common during the first half of the 20th century. They were strongly favored by governments, since they were mistakenly believed to offer three key advantages. First, they would lower the risk of speculative capital flows that could destabilize the economy. Second, they would introduce greater discipline on domestic policies to avoid inflation. Third, they would remove exchange rate risk and therefore promote international trade. It was thought that speculation would inevitably create unworkable volatility and destabilize a flexible, or freely floating, exchange rate. This would be a damaging for small economies that relied on a high level of international trade.
Unlike fixed exchange rates, these currencies float freely, that is, unrestrained by government controls or trade limits. In consequence, floating exchange rates are in continuous fluctuation. Changes in factors such as interest rates, inflation, political stability, trade flows, tourism and speculation, just to name a few, maintain free-floating currencies in continuous movement. This volatility is perceived as a positive aspect for currency speculators, who account for the vast majority of FX market trading. For companies carrying out business in foreign currencies, however, it poses translation and transaction risks that might seriously impact their profit margins. Theoretically, imbalances in the balance of payments lead to automatic changes in exchange rates.
A fixed exchange rate occurs when a country keeps the value of its currency at a certain level against another currency. Often countries join a semi-fixed exchange rate, where the currency can fluctuate within a small target level. Avoid currency fluctuations. If the value of currencies fluctuates, significantly this can cause problems for firms engaged in trade. Stability encourages investment. The uncertainty of exchange rate fluctuations can reduce the incentive for firms to invest in export capacity.
Let us make an in-depth study of the advantages and disadvantages of the flexible exchange rate system. The chief merit of the freely fluctuating exchange rate is that the BOP disequilibrium gets corrected automatically with the change in exchange rate. If a BOP deficit arises, there would be an excess supply of home currency leading to a fall in exchange rate simply by the market forces of demand and supply. This causes export goods cheaper and import goods dearer. As a result, export tends to rise while imports tend to decline—thereby removing deficit in the BOP account. Similarly, supply in the BOP account means excess demand for home currency and, thus, rise in the exchange rate. This, in turn, encourages imports and discourages exports.
The central bank of a country remains committed at all times to buy and sell its currency at a fixed price. The central bank provides foreign currency needed to finance payments imbalances. What are the main advantages and disadvantages of Fixed Exchange Rates?
The freely floating currency system is the predominant system of foreign exchange that is prevalent in the world today. As globalization has progressed, more countries have abandoned their currency pegs and have allowed their currencies to freely float. Some have been forced to do so by market participants whereas others have made their choice in the light of the advantages that this system has to offer. In this article, we will have a look at the advantages and disadvantages that are faced by any country when it adopts a floating exchange rate regime. Market Determined Rates: Freely floating exchange rate means that the market will determine the rate at which one currency can be exchanged for another.
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