Fixed Exchange Rates: Arguments for and against | International Economics

In this article we will discuss about the arguments for and against fixed exchange rates.

The advocates of a fixed or pegged or stable exchange rates advance arguments to justify this system or this type of exchange rate policy. At the same time, many arguments are advanced to criticize such a policy.

Arguments for Fixed Exchange Rates:

The main arguments in support of stable or pegged exchange rates are as follows:

(i) Promotion of International Trade:

If the exchange rates are fixed or stable, the prices of internationally traded goods become more stable and predictable. Under this system, the exporters know in advance what they will receive in terms of the domestic currency and importers know how much they will have to pay. Given such a certainty, which does not exist in a freely fluctuating exchange system, the international trade can definitely expand.

(ii) International Division of Labour and Specialisation:

The system of fixed exchange rate not only promotes international trade but also contributes in raising productivity and absolute output through increased international division of labour and specialisation.

(iii) Promotion of Economic Integration:

In an economic union, member countries strive to evolve a common currency. That is the necessary requirement for integrating their economic policies. The system of fixed exchange rate is just like a common currency in which the exchange value of the currency remains unchanged in terms of the domestic currency of a particular country.

So this system can pave the way for greater degree of economic integration among the countries. In this context, H.G. Johnson said, “The case for fixed rates is part of a more general argument for national economic policies conducive to international economic integration.”

(iv) Long-Term Capital Investments:

In case of stable exchange rates there is little uncertainty and risk. As a consequence, the investors can plan long-term international investments. Large scale capital inflows from abroad can facilitate the achievement of a higher rate of growth. The greater uncertainty and risk under the flexible exchange system, in contrast, is likely to impede the long- term capital flows.

(v) No Adverse Effect of Speculation:

Since the exchange rate remains stable under the fixed exchange system, there is little scope for speculation and the consequent adverse effects. The advocates of fixed exchange system point out that the speculation is destabilising under the flexible exchange system. The speculation is said to be destabilising, if speculators purchase a foreign currency when exchange rate is rising, and sell it when exchange rate is falling in the expectation that the exchange rate will change even more in the same direction.

Even if there is speculation in a fixed exchange system, there is little likelihood of its being of a destabilising character. Even if we do not enter the controversy whether the fixed exchange rate is stabilising or destabilising, it is clear that this policy will control and prevent speculation from having any adverse effect on the exchange rate in particular and the economy in general.

(vi) Confidence in the Strength of Currency:

This exchange system does not involve appreciation or depreciation of currency. There is no fear of risk of loss due to larger holding of foreign currency, if the value of currency declines. This imparts greater confidence in the strength of the domestic currency.

(vii) Suited to Currency Areas:

The system of fixed exchange rates is more suited to countries included in such regional arrangements as dollar area or sterling area or Euro-area. A fixed rate of exchange between dollar and sterling with other currencies is likely to have very positive effect on trade. BOP adjustments, capital flows and growth. The flexible exchange system in these currency areas is likely to lead to chaotic conditions and create serious problems in payment adjustments.

(viii) Beneficial for Trade-Dependent Countries:

Certain countries like England, France, Japan and Belgium have excessive dependence on foreign trade. The contribution of external trade in the gross national product in their case is quite high. The recurring fluctuation in the rates of exchange can create serious dislocations in trade and domestic production. Thus the whole economic system is likely to be in jeopardy. It is imperative that trade-dependent countries should have more stable exchange rates.

(ix) Growth of Money and Capital Markets:

The system of stable exchange rate stimulates the growth of money and capital markets through facilitating rapid expansion of trade and international capital flows. When there existed stable exchange rates under gold standard, smooth flow of international lending continued and that brought about steady expansion in international money markets.

In contrast, competitive exchange depreciation during the inter-war period had serious disruptive effect upon international capital flows and upon the growth of money and capital markets.

(x) Price Discipline:

Fixed exchange rates, involve a price discipline on the nation that is not present under a flexible exchange system. The democratically elected governments are often tempted to follow expansionary policies which reduce unemployment but cause inflationary pressures. A country having a higher rate of inflation than the rest of the world is likely to face persistent BOP deficits and loss of reserves. This cannot go on forever. Therefore, the country under a fixed exchange rate will have to adopt measures to restrain inflation.

There is no such price discipline under flexible exchange system because it is assumed that the BOP disequilibria are corrected automatically and immediately through changes in exchange rates. It is, therefore, clear that fixed exchange system involves price discipline. This argument is also referred as ‘Anchor’ argument.

In this connection, Sodersten commented, “Fixed exchange rates can serve as an anchor. Inflation will cause balance of payments deficits and reserve losses. Hence the authorities will have to take counter-measures to stop inflation. Fixed exchange rates should, therefore, impose a ‘discipline’ on governments and stop them from pursuing inflationary policies which are out of tune with the rest of the world.”

Arguments against Fixed Exchange Rates:

The main arguments against the fixed or pegged rates of exchange are as follows:

(i) Primacy to Exchange Stability:

A serious defect in this system of exchange rates is that the authorities become concerned primarily with the maintenance of exchange rate at some official level. It often results in the sacrifice of the objectives of price stability and full employment. In a country under fixed exchange system, the BOP deficit can be corrected through deflationary policies that may result in a fall in prices, recession and greater unemployment.

Similarly the correction of BOP surplus will require inflationary policies. Thus the society has to bear a much heavier cost for maintaining stable exchange rates. In contrast, the flexible exchange system makes BOP adjustments through exchange variations and there is no need to sacrifice internal stability.

(ii) International Transmission of Economic Variations:

The fixed or stable exchange rates can be responsible for transmitting the economic disturbances in one country to another. Suppose there are deflationary conditions in one country. It will export its low-price goods to other countries. The industries of foreign countries, faced with competition from cheap goods, will be forced to lower their prices.

Thus deflationary conditions get transmitted. Similarly the inflationary trends in one country will get transmitted to the other countries. In this way, the economic variations, under the fixed exchange system, leak out from one country to its trading partners and vice-versa.

(iii) Need to Build Exchange Reserves:

The necessity of maintaining the exchange rate at an official level makes the authorities to undertake pegging operations. For this purpose, it is necessary to maintain sufficient reserves of foreign currencies. Unless these reserves are maintained, a country faced with BOP deficit will have to depend upon devaluation. The holding of large reserves of foreign currencies in the idle form is clearly costly, uneconomical and wasteful. Under the flexible exchange system, there is no uneconomic build-up of international liquid reserves.

(iv) Heavy Burden upon the Authorities:

If a country is under continuous pressure on account of the BOP deficit, the government or monetary authority may not be in a position to mobilise sufficient international liquid resources for undertaking the pegging operations. In the event of failure to mobilise reserves of foreign currencies, the home currency has to be devalued.

Sometimes this step might have to be adopted repeatedly within a short span. Such a situation will seriously undermine the strength of the home currency and the accompanying loss of confidence in it.

(v) Difficulty in Building Up of Exchange Reserves:

Under a fixed exchange system, every country is required to build up idle stock of foreign currencies. It necessitates the BOP surplus at least for some years. The LDC’s will find it difficult to have BOP surpluses for building up sufficient foreign exchange reserves. It is often beyond their capacity to even offset the persistent BOP deficit.

(vi) Possibility of Speculation:

It is generally believed that in a system of fixed exchange rate, there is little scope for speculation in foreign exchange. In this connection, it must be recognised that speculation, undoubtedly, will not occur in respect of variations in exchange rates but the speculators can still make anticipations about the timing and extent of possible devaluation or about the timing and scale of pegging operations.

For instance, delay on the part of British government to devalue pound sterling in 1967, permitted the speculators, who were shrewd enough to sell sterling in the forward market immediately prior to the date of devaluation, for making a tidy profit in the process.

(vii) Exchange Controls:

The policy of fixed or stable exchange rates requires quite complicated exchange control mechanism. This can result in misallocation of economic resources, bureaucratic inefficiency and corruption.

(viii) No Solution of BOP Problem:

The policy of fixed exchange rates cannot help in resolving the problem of BOP deficit. It simply suppresses it through the government intervention. The forces underlying the BOP disequilibrium remain to be tackled through monetary, fiscal and other policies. Under this system, the entire attention is paid to the stabilization of exchange rate rather than dealing with the BOP disequilibrium. The stabilisation of exchange rate itself becomes the end and no longer remains a means to adjust the BOP disequilibrium.

(ix) Suited only of Short Period:

The policy of fixed exchange rates cannot be pursued as a long-term policy. As technological and structural changes take place, the official rate of exchange may be rendered unrealistic. The BOP difficulties and fluctuations in international commodity prices can force the different countries to revise the exchange rates.

It brings home the point that the fixed or pegged exchange rate policies are suited at the most over a short period. In the long run, the fixed exchange rates are both practically impossible and economically inefficient.

(x) Greater Need of Institutional Arrangements:

In case of a flexible exchange system, the BOP adjustments can take place automatically through free movements of exchange rates. But in the fixed exchange system, the BOP adjustments require accommodating transactions. The countries on fixed exchange rates have to rely upon the international lending institutions to overcome their recurring needs of liquidity.