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Advantages and disadvantages of exchange rate systems

Advantages and disadvantages of fixed exchange rates

Advantages of fixed exchange rates

  • Certainty - with a fixed exchange rate, firms will always know the exchange rate and this makes trade and investment less risky.
  • Absence of speculation - with a fixed exchange rate, there will be no speculation if people believe that the rate will stay fixed with no revaluation or devaluation.
  • Constraint on government policy - if the exchange rate is fixed, then the government may be unable to pursue extreme or irresponsible macro-economic policies as these would cause a run on the foreign exchange reserves and this would be unsustainable in the medium-term.

Disadvantages of fixed exchange rates

  • The economy may be unable to respond to shocks - a fixed exchange rate means that there may be no mechanism for the government to respond rapidly to balance of payments crises.
  • Problems with reserves - fixed exchange rate systems require large foreign exchange reserves and there can be international liquidity problems as a result.
  • Speculation - if foreign exchange markets believe that there may be a revaluation or devaluation, then there may be a run of speculation. Fighting this may cost the government significantly in terms of their foreign exchange reserves.
  • Deflation - if countries with balance of payments deficits deflate their economies to try to correct the deficits, this will reduce the surpluses of other countries as well as deflating their own economies to restore their surpluses. This may give the system a deflationary bias.
  • Policy conflicts - the fixed exchange rate may not be compatible with other economic targets for growth, inflation and unemployment and this may cause conflicts of policies. This is especially true if the exchange rate is fixed at a level that is either too high or too low.

Advantages and disadvantages of floating exchange rates

Advantages of floating exchange rates

  • Protection from external shocks - if the exchange rate is free to float, then it can change in response to external shocks like oil price rises. This should reduce the negative impact of any external shocks.
  • Lack of policy constraints - the government are free with a floating exchange rate system to pursue the policies they feel are appropriate for the domestic economy without worrying about them conflicting with their external policy.
  • Correction of balance of payments deficits - a floating exchange rate can depreciate to compensate for a balance of payments deficit. This will help restore the competitiveness of exports. There is a link to Figure 1 below which illustrates the operation of the automatic adjustment mechanism under a floating exchange rate system.

Figure 1 - automatic correction of a balance of payments deficit

Disadvantages of floating exchange rates

  • Instability - floating exchange rates can be prone to large fluctuations in value and this can cause uncertainty for firms. Investment and trade may be adversely affected.
  • No constraints on domestic policy - governments may be free to pursue inappropriate domestic policies (e.g. excessively expansionary policies) as the exchange rate will not act as a constraint.
  • Speculation - the existence of speculation can lead to exchange rate changes that are unrelated to the underlying pattern of trade. This will also cause instability and uncertainty for firms and consumers.