Advantages and Disadvantages of Fixed Exchange Rate

Fixed Exchange Rate

It is an exchange rate system put in place by the Central Bank or Government that is tied to the nation's official currency exchange rate to another nation's currency or the price of gold. This system is also referred to as pegged exchange rate system.

The primary objective of the fixed exchange rate system is to maintain the currency's worth the under the narrow band.

Justification For the Usage of Fixed Exchange Rate System

It offers imports and exports greater certainty. Major developed economies follow the floating exchange rate systems. These developed nations began with this practice in the early 1970 but developing economies follow fixed-rate systems.

Bretton Woods

From the end of World War II to the 1970s, the Bretton Woods Agreement paved the way for participating countries to be pegged to the value of the US dollar, which was fixed to the value of gold.

Examples of Fixed Exchange Rate

There are various ways in which the nation can keep the fixed exchange rate stable. One of the best ways is to achieve this when the currency is pegged to a set value against a single currency, but some nations set a value to a basket of currencies rather than a single currency. Then, it permits fluctuation between the range of pegged currency. Some of the examples are:

Currencies whose value is fixed at a single currency: These countries commit that they will offer the same amount in their currency for each unit of currency to which it is set.

International Monetary Fund released this list in April 2019.

The 14 nations have adopted Common Fixed currencies, and seven nations in Central Africa have adopted Central African Franc. The nations include the Republic of the Congo, Equatorial Guinea, Cameroon, Gabon, Chad, Central African Republic, and Cameroon. Seven nations in West Africa have adopted West African Franc, including Senegal, Burkina Faso, Benin, Niger, Ivory Coast, Togo, and Guinea-Bissau. Each currency is aligned with the euro at a ratio of 655.957 CFA to one euro.

Four nations have adopted fixed exchange rate mechanisms but set them against the basket of currencies instead of a single currency: Libya, Fiji, Kuwait, and Morocco.

Loosely Fixed Currency

These nations have set their currency to their trading range, which is aligned to either a basket of currencies or a single.

Advantages of the Fixed Exchange Rate System

1. Promotes Capital Movements

This system helps facilitate the capital movement of private firms. A stable currency does not create any uncertain atmosphere regarding capital loss because of changes in the exchange rate. It helps in attracting a large number of foreign capital investments. Foreign investors are disinterested in those countries whose currency is in an unstable phase. Foreign investment is the major source of earnings for any nation. Therefore, the fixed exchange rate system provides a faster way for economic growth in the world's developing economies.

2. Prevent Speculation in the Foreign Exchange Market

One of the significant advantages of the fixed exchange rate system is that it does not create an atmosphere of speculation and uncertainty in the foreign exchange market system. The operators try to gain profit from fluctuation in the exchange rate system that is decided by the supply and demand forces. Experts have pointed out that the unstable and flexible exchange rate gives much heat to speculation in the foreign exchange market system.

They attempt to manipulate the exchange rate by selling and buying foreign exchange and try to gain maximum from the speculative gain. A study by Ragnar Nurkse in the era of the twenties found that flexible and speculative exchange rate systems destabilized the economy. Removing the speculation from the foreign exchange market provides more stability in the market. It creates more fluctuations in the market system.

3. Offers Exchange Rate Stability

Experts in the defense have given an argument that this system of exchange rate offers to provide more stability than any others. If the exchange rate were unstable and flexible, the global supplier would be in confusion about what price they would receive from the importing countries and the payment they have to give to the importing countries. It is being said that exchange rate stability became one of the necessary conditions for the orderly development of the international economy and faster growth for global trade.

4. Essential for Small Nations

Fixed exchanges are even important for tiny nations like Belgium, the United Kingdom, and Denmark, where foreign trade plays an important role. Fluctuating fixed exchange rate systems will create unwanted hurdles in the process of economic growth of these economies.

5. Behave as an Anchor Against Inflation

One of the advantages of the fixed exchange system is that it dissuades the countries' governments from undertaking inflationary policies. The Government often goes with high fiscal and monetary policies to decrease unemployment and booming the economy.

It expedites income inequalities and hurts the vulnerable class the most. Inflation hurts the economic growth of the nations in the long term. The Fixed Exchange system binds the Government to adopt the anti-inflationary approach. Inflation will directly impact the balance of payment deficit and create a loss of international reserves. It makes the Government check inflationary pressures.

6. Fosters Economic Integration in the Globe

One of the arguments regarding the foreign exchange rate is that it aims to attain economic integration in the global community. It is similar to the concept that the Single Currency system would help facilitate the unrestricted movement of finance among different regions of the nations, seamless trade, and communication. Creating a healthy competitive atmosphere between the consumer and producers of various countries. It also creates a cord between the countries to form unions and groups.

Disadvantages of Fixed Exchange Rate

1. Hindrance in the Macroeconomic Objectives

The fixed Exchange Rate System has come under strict criticism for its conflict with macroeconomic objectives, for example, sustainable economic growth. It gives rise to currency value fluctuations, making it difficult for the borrower to take money from the international market. It also has a risk factor for the importing countries that their currencies may become weak against the nations. In the Fixed exchange rate system, the state determines the single currency value for all nations, which means that market forces do not have a role in determining value.

2. Inflexible System

One of the system's demerits is that it is inflexible. For example, if a nation's currency is weak, it has to devalue its currency to increase its products. It may cause higher inflation and will slow down economic growth. It will widen the trade deficits, which would mean the import is higher than the export, creating many economic hurdles for the coming generations.

3. Higher Rate of Interest

It demands a higher rate of interest to keep the value of the currency stable. A higher interest rate impacts borrowing and makes the corporate world borrow money. Foreign goods become more expensive and reduce the purchasing power of the people.

4. The Currency's Value Remains Dynamic

The currency value remains dynamic, and the issue arises when there is a large trade deficit. In the case of a large trade deficit, currency value declines.