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Merits and demerits of fixed and flexible foreign exchange rates.
Merits of fixed exchange rate:
1. It ensures stability in exchange rate. The exporters and importers have not to operate under uncertainty about the exchange rate. Thus it promotes foreign trade.
2. It promotes capital movements. Fixed exchange rate system attracts foreign capital because a stable currency does not involve any uncertainties about exchange rate that may cause capital loss,
3. Stable exchange rate prevents capital outflow
4. It prevents speculation in foreign exchange market
5. It forces the government to keep inflation in check. In case of fixed exchange rate system,inflation causes balance of payments deficit resulting in depletion of foreign exchange reserves.
Demerits of fixed exchange rate:
1. It contradicts the objective of having free markets
2. Under this system, countries with deficits in balance of payment run down this stock of gold and foreign currencies. This can create serious problem for them. They may be forced to devalue their currency. On the other hand countries with surplus in balance of payments will face the problem of inflation.
3. There may be undervaluation or overvaluation of currency. If the fixed exchange rate is at a level which is lower then the market level i.e. at which demand for foreign currency far exceeds its supply, its will result in deficit in balance of payment. If it is higher than the market level i.e. at which the supply exceeds demand then it may create inflationary pressure because of balance of payments surplus. It is difficult to fix a rate that may prove to be equilibrium rate
Merits of flexible exchange rate system
1. It eliminates the problem of overvaluation or undervaluation of currencies, Deficit or surplus in balance of payments is automatically corrected under this system.
2. It frees the government from problem of balance of payments.
3. There is no need for the government to hold any reserves.
4. It enhances the efficiency in the economy by achieving optimum resource allocation.
Demerits of flexible exchange rate system
1. It creates situations of instablility and uncertainty. Wide fluctuations in exchange rate are possible. This hampers foreign trade and capital movements between countries.
2. It encourages speculation which may lead to larger uncertainties and fluctuations.
3. The uncertainty caused by currency fluctuations can discourage international trade and investment.
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