Advantages &Disadvantages of Fixed and floating Exchange

Rate Systems

Advantages of fixed 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.

Advantages of fixed exchange rates

1. Avoid currency fluctuations. If the value of currencies fluctuates, significantly this can cause
problems for firms engaged in trade.

• For example, if a firm is exporting, a rapid appreciation in Sterling would make its exports
uncompetitive and therefore may go out of business.
• If a firm relies on imported raw materials, a devaluation would increase the costs of imports and
would reduce profitability.

2. Stability encourages investment. The uncertainty of exchange rate fluctuations can reduce
the incentive for firms to invest in export capacity. Some Japanese firms have said that the UK’s
reluctance to join the Euro and provide a stable exchange rate makes the UK a less desirable
place to invest. A fixed exchange rate provides greater certainty and encourages firms to invest.

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3. Keep inflation low. Governments who allow their exchange rate to devalue may cause
inflationary pressures to occur. Devaluation of a currency can cause inflation because AD
increases, import prices increase and firms have less incentive to cut costs.

• AD increases (higher demand for exports), import prices increase, and firms have less incentive
to cut costs.
• Import prices increase.
• Firms have less incentive to cut costs.

A fixed exchange rate, by contrast, means firms have an incentive to keep cutting costs to remain
competitive.

It is hoped a fixed exchange rate will reduce inflationary expectations.

4. Current account. A rapid appreciation in the exchange rate will badly effect manufacturing
firms who export; this may also cause a worsening of the current account.

Disadvantage of fixed exchange rates

1. Conflict with other macroeconomic objectives.

To maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives.

If a currency is under pressure and falling – the most effective way to increase the value of a
currency is to raise interest rates. This will increase hot money flows and also reduce inflationary
pressures. However higher interest rates will cause lower aggregate demand (AD) and lower
economic growth, If the economy is growing slowly this may cause a recession and rising
unemployment.

2. Less flexibility. In a fixed exchange rate, it is difficult to respond to temporary shocks. For
example, if the price of oil increases, a country which is a net oil importer will see a deterioration
in the current account balance of payments. But in a fixed exchange rate, there is no ability to
devalue and reduce current account deficit.

3. Join at the wrong rate. It is difficult to know the right rate to join at. If the rate is too high, it will
make exports uncompetitive. If it is too low, it could cause inflation. In the late 1980s, the UK
chancellor, Nigel Lawson tried to shadow the DM and keep Sterling low; this led to a rise in
inflation. In 1990, the UK joined the ERM, but the rate proved too high and trying to keep the
value of the Pound high led to high-interest rates and the recession of 1991/92.

4. Require higher interest rates.

If the currency is falling below the exchange rate floor, the government may be forced to put up
interest rates – even if this is unsuitable for the economy. For example, in 1992, the government
was trying to keep Pound Sterling in the ERM, but the value was falling. Therefore, the

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government increased interest rates to 15% – but this was very damaging – causing mortgage
defaults and the recession of 1991/92

5. Current account imbalances. Fixed exchange rates can lead to current account imbalances.
For example, an overvalued exchange rate could cause a current account deficit.

6. Difficulty in keeping the value of the currency – If a currency is falling below its band the
government will have to intervene. It can do this by buying sterling but this is only a short-term
measure. If membership of a fixed exchange rate is short-lived in defeats the purpose and rather
than gradual changes in the exchange rate, there is added uncertainty and speculation about the
exchange rate.

7. Encourage speculative attacks. Some argue a fixed exchange rate would encourage stability
and therefore there is no point investors ‘speculating against the currency’ However, speculators
know if the currency is fundamentally misvalued, then the government may have to leave
exchange rate altogether.

Advantage of Floating Exchange Rates:

1. Automatic Stabilisation:
Any disequilibrium in the balance of payments would be automatically corrected by a change in
the exchange rate. For example, if a country suffers from a deficit in the balance of payments
then, other things being equal, the country’s currency should depreciate.

This would make the country’s exports cheaper, thus increasing demand, while at the same time
making imports expensive and decreasing demand. The balance of payments equilibrium would
therefore be restored. On the contrary, a balance of payments surplus would be automatically
eliminated through a change in the exchange rate.

2. Freeing Internal Policy:

Under the floating exchange rate system the balance of payments deficit of a country can be
rectified by changing the external price of the currency. On the country if a fixed exchange rate
policy is adopted, then reducing a deficit could involve a general deflationary policy for the whole
economy, resulting in unpleasant consequences such as unemployment and idle capacity.

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Thus, a floating exchange rate allows a government to pursue internal policy objectives such as
full employment growth in the absence of demand-pull inflation without external constraints (such
as debt burden or shortage of foreign exchange).

3. Absence of Crisis:
The periods of fixed exchange rates were frequently characterised by crisis as too much pressure
was put on central bank to devalue or revalue the country’s currency. However, the central bank
that devalued a currency by giving out too much of it would soon either stop or run out of it.

Similarly the central banks that revalued a currency by giving out too little of it in exchange for
other currencies would soon be flooded with that currency as it would get relatively large amounts
of other currencies. Under floating exchange rate system such changes occur automatically.
Thus, the possibility of international monetary crisis originating from exchange rate changes is
automatically eliminated.

4. Management:
under the floating exchange rates system national governments enjoy considerable discretion.
To be more specific, governments are free to manipulate the external value of their currency to
their own advantage.

5. Flexibility:
Changes in world trade since the first oil crisis of 1973 have caused great changes in the values
of currencies. How these could have been dealt with under a system of fixed exchange rate is not
yet clear.

6. Avoiding Inflation:
“A floating exchange rate helps to insulate a country from inflation elsewhere. In the first
place, if a country were on a fixed exchange rate then it would ‘import’ inflation by way of
higher import prices. Secondly, a country with a payments surplus and a fixed exchange
rate would tend to ‘import’ inflation from deficit countries.”
7. Lower Reserves:
Finally, floating exchange rates should mean that three is hardly any need to
maintain large reserves to develop the economy. These reserves can therefore
be fruitfully used to import capital goods and other items in order to promote
faster economic growth.

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Floating exchange rates have the following disadvantages:
1. Uncertainty:
The very fact that currencies change in value from day to day introduces a
large element of uncertainty into trade. A seller may not be quite sure of how
much money he will receive when he sells goods abroad. Some of this
uncertainty may be reduced by companies buying currency ahead in forward
exchange contracts.

2. Lack of Investment:
The uncertainty introduced by floating exchange rates may discourage direct
foreign investment (i.e., investment by multinational companies).

3. Speculation:
The day-to-day fluctuations in exchange rates may encourage speculative
movements of ‘hot money’ from country to country, thereby cause more and
mooring exchange rate fluctuations.

4. Lack of Discipline:
The need to maintain an exchange rate imposes a discipline upon the national
economy. It is quite possible that with a floating exchange rate such short-run
problems as domestic inflation may be ignored until they have created crisis
situations.

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