Let us make an in-depth study of the advantages and disadvantages of the flexible exchange rate system.
Advantages:
(i) Automatic Adjustment in BOP:
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. As a result, the BOP accounts will reach equilibrium by the same logic. Thus, this exchange rate makes an automatic adjustment in the BOP crisis of an economy and that too without governmental intervention.
(ii) No Collusion Between Internal-External Objectives:
ADVERTISEMENTS:
Surplus and deficit in the BOP accounts get corrected if foreign exchange rate falls and rises, respectively. In a regime of fixed exchange rate, the removal of BOP deficit requires the adoption of internal policies like fall income and price level. In other words, pegged exchange rate requires a change in domestic macroeconomic policies like deflationary policies of price and output reduction.
But, under flexible exchange rate system, a government can adopt independent monetary policy. In other words, under this system of exchange rate, internal balance could be maintained by the government. It is further argued that, as it is a self-adjusting mechanism to restore BOP equilibrium, a government can put more effort in tackling internal problems of inflation, unemployment, etc.
(iii) Absorption of Sudden Shocks:
In a flexible exchange rate, the domestic economy remains insulated from external shocks and pressures. Under this system, the threat of ‘importing inflation’ from outside the country is minimum. In other words, price feedback effect is imperceptible.
(iv) Minimum Buffer of Foreign Exchange Reserves:
Since exchange rate is not pegged under the floating arrangement of exchange rate, the central bank of a country need not hold adequate foreign exchange reserves as a buffer against unforeseen developments in international trade.
Disadvantages:
(i) Uncertainty and Confusion:
Flexible exchange rate and trade presents an atmosphere of uncertainty and confusion in trade and investment. Susceptibility to uncertainty is greater as soon as exchange rate fluctuates freely. Suppose an Indian has despatched an export ‘invoice’ to the foreign buyers. But the Indian exporters do not know at what price foreign currency will be converted into Indian currency. This kind of uncertainty hampers trade. However, such uncertainty can be largely minimised through forward exchange contracts. The uncertainty involved in this kind of exchange rate may cause trading community to lose some confidence in the system.
(ii) Hampering Investment:
ADVERTISEMENTS:
Unregulated free- floating exchange rate often discourages foreign investment as exchange rate becomes erratic and, hence, destabilising. Because of the uncertainty associated with this exchange rate involving profit and loss implications of foreign investment deals, a country might experience decumulation of capital. Hence—it is destabilising in effect.
(iii) Risk, Instability, and Speculation:
Flexible exchange rate encourages wide speculation since foreign exchange prices are not known in advance as in fixed exchange rate. It is because of speculation there occurs disruptive hot money flows. To put it elaborately, it can be argued that when the exchange rate tends to decline, speculators anticipate that such would continue to decline further and the possibility of the flight of money to another country will brighten. This will then cause a further fall in the exchange rate. Thus, greater the speculation against a currency, the deeper the economic crises.
However, economists are not unanimous about this kind of speculation associated with the flexible exchange rate system.
(iv) Inflationary in Character:
ADVERTISEMENTS:
By nature, flexible exchange rate is inflationary. As soon as the exchange rate falls, automatically, consequent upon the BOP deficit, import goods become expensive. High cost of imported goods then fuels inflationary tendencies. As depreciation of a currency makes import costlier, the domestic economy faces both demand-pull and cost-push inflationary pressures.
It is because of these drawbacks of the freely fluctuating exchange rate that countries attach importance to ‘managed exchange rate’ with their central banks buying and selling currencies in the foreign exchange market so as to moderate the degree of fluctuations as far as practicable.