Difference between Fixed and Flexible Exchange Rate System

This article will help you to learn about the difference between fixed and flexible exchange rate system.

Difference between Fixed and Flexible Exchange Rate System

There may be variety of exchange rate systems (types) in the foreign exchange market. Its two broad types or systems are Fixed Exchange Rate and Flexible Exchange Rate as explained below.

In between these two extreme rates, there are some hybrid systems like Crawling Peg, Managed Floating.

Broadly when government decides the conversion rate, it is called fixed exchange rate. On the other hand, when market forces determine the rate, it is called floating exchange rate.

Fixed Exchange Rate System:

Fixed exchange rate is the rate which is officially fixed by the government or monetary authority and not determined by market forces. Only a very small deviation from this fixed value is possible. In this system, foreign central banks stand ready to buy and sell their currencies at a fixed price. A typical kind of this system was used under Gold Standard System in which each country committed itself to convert freely its currency into gold at a fixed price.

In other words, value of each currency was defined in terms of gold and, therefore, exchange rate was fixed according to the gold value of currencies that have to be exchanged. This was called mint par value of exchange. Later on Fixed Exchange Rate System prevailed in the world under an agreement reached in July 1994.

The advantages and disadvantages of this system are as under:

Merits:

(i) It ensures stability in exchange rate which encourages foreign trade, (ii) It contributes to the coordination of macro policies of countries in an interdependent world economy, (iii) Fixed exchange rate ensures that major economic disturbances in the member countries do not occur, (iv) It prevents capital outflow, (v) Fixed exchange rates are more conducive to expansion of world trade because it prevents risk and uncertainty in transactions, (vi) It prevents speculation in foreign exchange market.

Demerits:

(i) Fear of devaluation. In a situation of excess demand, central bank uses its reserves to maintain foreign exchange rate. But when reserves are exhausted and excess demand still persists, government is compelled to devalue domestic currency. If speculators believe that exchange rate cannot be held for long, they buy foreign exchange in massive amount causing deficit in balance of payment. This may lead to larger devaluation. This is the main flaw or demerit of fixed exchange rate system, (ii) Benefits of free markets are deprived; (iii) There is always possibility of under-valuation or over-valuation.

Flexible Exchange Rate System:

The system of exchange rate in which rate of exchange is determined by forces of demand and supply of foreign exchange market is called Flexible Exchange Rate System. Here, value of currency is allowed to fluctuate or adjust freely according to change in demand and supply of foreign exchange.

There is no official intervention in foreign exchange market. Under this system, the central bank, without intervention, allows the exchange rate to adjust so as to equate the supply and demand for foreign currency In India, it is flexible exchange rate which is being determined. The foreign exchange market is busy at all times by changes in the exchange rate. Advantages and disadvantages of this system are listed below:

Merits:

(i) Deficit or surplus in BOP is automatically corrected, (ii) There is no need for government to hold any foreign exchange reserve, (iii) It helps in optimum resource allocation, (iv) It frees the government from problem of BOP

Demerits:

(i) It encourages speculation leading to fluctuations in foreign exchange rate, (ii) Wide fluctuation in exchange rate hampers foreign trade and capital movement between countries, (iii) It generates inflationary pressure when prices of imports go up due to depreciation of currency.

Managed Floating:

This refers to a system of gradual adjustments in the exchange rate deliberately made by a central bank to influence the value of its own currency in relation to other currencies. This is done to save its own currency from short-term volatility in exchange rate caused by economic shocks and speculation. Thus, central bank intervenes to smoothen out ups and downs in the exchange rate of home currency to its own advantage.

When central bank manipulates floating exchange rate to disadvantage of other countries, it is termed as dirty floating. However, central banks have no fixed times for intervention but have a set of rules and guidelines for this purpose.

Distinction between Fixed Exchange Rate and Flexible Exchange Rate:

Fixed exchange rate is the rate which is officially fixed in terms of gold or any other currency by the government. It does not change with change in demand and supply of foreign currency. As against it, flexible exchange rate is the rate which, like price of a commodity, is determined by forces of demand and supply in the foreign exchange market. It changes according to change in demand and supply of foreign currency. There is no government intervention.