Flexible Exchange Rates System: Merits and Demerits

Here we detail about the merits and demerits of flexible exchange rates system.

Merits of Flexible Exchange Rates System:

Under the flexible exchange rate system, exchange rate between different currencies, like the prices of commodities are freely determined by market forces, that is, by demand and supply forces.

With the change in economic conditions underlying demand and supply, the exchange rate will automatically change without any intervention by the Government. That is why, it is called flexible or variable exchange rate system.

It has the following merits:

1. Problems of Undervaluation and Overvaluation are Avoided:

The advocates of flexible exchange rates contend that under it the problems of undervaluation and overvaluation of currencies which are found in the fixed exchange rate system are avoided. Whenever there is deficit in balance of payments implying overvaluation of the national currency under the flexible exchange rates, it will depreciate (that is, its value will fall) which on the one hand will make exports cheaper and thereby encourage them and on the other will make the imports costlier than before which will tend to discourage them. Thus, increase in exports and decline in imports as a result of depreciation will lead to the automatic correction in the balance of payments.

On the other hand, whenever there is surplus in the balance of payments, the exchange rate will appreciate which will tend to reduce exports and raise imports. This again will tend to automatically restore the balance of payments equilibrium.

This is how the flexible exchange system works to ensure the equilibrium in the balance of payments. To quote Prof. Soderston, “The same factors which under the fixed rates give rise to deficits and surpluses in the balance of payments would under floating rates make the exchange rate depreciate or appreciate. Thereby equilibrium would be preserved and the Government could be freed from consideration regarding external balance”.

2. Promotes Growth of Multilateral Trade:

The advocates of flexible exchange rates system are strongly of the view that as unlike fixed exchange rates system, this does not create serious and difficult problems, it will ensure rapid growth of multilateral world trade. Further, they point out that promotion of world trade under the flexible exchange rates would not interfere in any way the adoption of policies to achieve domestic economic stability.

3. Flexible Exchange Rates does not Necessarily Show Large Fluctuations:

It has been pointed out in defence of the flexible exchange rates that the problems of undervalued or overvalued currency found under the fixed exchange rate regime are not found in the flexible exchange rate system. Further, it is contended that exchange rates being flexible does not necessarily mean there will be large fluctuations in them. Even under flexible exchange system there need not be large fluctuations in exchange rates.

According to them, changes in exchange rates will occur only when economic conditions underlying demand for and supply of foreign currencies change. Further, according to them, random fluctuations around the normal exchange rates would be smoothened out through operations by private speculators. Thus, according to Soderston “if the currency appreci­ated above its equilibrium value, if its price fell in terms of foreign currency, speculators would buy the currency; and if it depreciated, speculators would sell the currency. Thereby they would smooth out fluctuations and help to keep the exchange rate stable. If the underlying conditions changed, however the price of foreign exchange would also change.”

4. It Ensures Individual Freedom:

The system of floating exchange rate is advocated on the basis of philosophy that Government should intervene in the economy as little as possible and the indi­viduals should be left free to pursue their economic interests.

It has been noted above the alternative to floating exchange rates system is the fixed exchange rates which require controls and restrictions which are implemented by experts who generally do not work under effective democratic controls. Generally, they fix the exchange rate out of consideration for other than economic objectives, for example for the purpose of retaining a certain market structure or influencing income distribution.

5. It Frees the Government from Problems of Balance of Payments:

A great merit of flexible exchange rates is that it frees the Government from problems of balance of payments. As has been seen above, the fixed exchange rates system leads either to deficit or surplus in balance of payments. Under this system the Government remains preoccupied with the questions of devaluation or revalu­ation of their currencies.

Since floating exchange rates work automatically to restore balance of payments equilibrium, the Government need not pay any attention to the balance of payments. In­stead, the Governments can concentrate on solving their domestic problems of economic stability, inflation and unemployment. “Flexible exchange rates should therefore give an increased freedom both to individuals and countries to pursue whatever aims they have for their economic policies.”

Demerits of Flexible Exchange Rate System:

Flexible exchange rates system is also not without shortcomings. It has been opposed on some important grounds.

We briefly explain below some important arguments given against flexible ex­change rates:

1. Flexible Exchange Rates Create a Situation of Instability and Uncertainty:

An important argument against flexible exchange rates is that too frequent fluctuations in exchange rate under it create uncertainty about the exact amount of receipts and payments in foreign exchange transac­tions. This instability hampers foreign trade and capital movements between the countries.

How­ever, Friedman does not accept this charge against flexible exchange rates. He argues that flexible exchange rate is not necessarily an unstable exchange rate. According to him, it is the underlying economic conditions determining foreign trade that often change causing changes in the foreign exchange rate and for this the flexible exchange rates should not be blamed.

2. Dampening Effect on Foreign Trade:

Under the flexible exchange rates, the price of for­eign exchange or international value of the national currency is quite uncertain. As a result, they are unable to take proper decisions regarding exports and imports of goods. Obviously, this has a damp­ening effect on the volume and growth of foreign trade.

However, Friedman does not agree with this and points out that traders can always protect themselves against risks arising out of the changes in the exchange rate by hedging in the future market. However, Soderston has challenged this view of Friedman and points out that no markets exist today that can protect traders against risks arising out of flexible exchange rates.

It may however be noted that from the empirical evidence since 1971 when exchange rates have been flexible, it does not appear that flexible exchange rates have a dampening effect on the growth of foreign trade. In fact, the growth of world trade since 1971 has been fairly good.

3. Widespread Speculation with a Destabilising Effect:

The system of flexible exchange rates has been opposed on the ground that under it there is widespread speculation regarding ex­change rates of currencies which has a large destabilising effect on these rates. Friedman, on the other hand, contend that speculation has a stabilising influence on exchange rates. However, whether or not speculation has a destabilising or stabilising effect is a highly controversial issue in economics which has so far remained unresolved.

4. Provides an Inflationary Bias to an Economy:

Another shortcoming of the flexible, ex­change rates is that they have an inflationary impact on the economy. It has been pointed out that whenever due to deficit in balance of payments, the currency depreciates, the prices of imports go up. The higher prices of imported materials raise the prices of industrial products and thus generate cost-push inflation.

However, in defence of flexible exchange rates, it has been pointed out that when demand for imports decline due to appreciation of national currency, the foreign suppliers are compelled to reduce their prices to protect markets. Through this reduction in prices in the face of declining demand is theoretically possible, it may not happen in actual practice.

To sum up, there are merits and demerits of flexible exchange rate system. Whether a flexible exchange rate systems suits an economy depends on circumstances. It depends on characteristics of the economy which adopts flexible exchange rate system.

Further, it may be noted that since 1971 when Bretton Woods System representing the fixed exchange rate system was abandoned, it is not perfectly free flexible exchange rate system that has been adopted. Instead, it is what is called Managed Float System that has been prevailing.

Under the managed float system, the exchange rates are flexible, that is, they change as a result of changes in demand and supply of currencies, but the Government or Central Bank intervenes through demand and supply to keep the variations in exchange rate within certain limits so as to ensure stability and certainty of the foreign exchange rates.