Fixed & Flexible Exchange Rate Systems

advantages and disadvantages

give 3 advantages of flexible exchange rate systems

1. automatic correction

2. no problem of internal liquidity

3. governments free to choose domestic policy

automatic correction

exchange rates adjust naturally to balance trade and capital flow

no problem of international liquidity and reserves

no need to maintain large foreign reserves to defend the currency

governments free to choose domestic policy

monetary and fiscal policy can focus on domestic goals without defending a fixed rate

give 3 disadvantages of flexible exchange rates

1. speculation

2. uncertainty for traders and investors

3. lack of discipline on the domestic economy

speculation

currency values can be highly volatile due to speculative trading

uncertainty for traders and investors

businesses face exchange rate risk, affecting planning and investment

lack of discipline on the domestic economy

governments may overspend or mismanage policy since currency is not fixed

give 2 advantages of fixed exchange rate

1. ecnourages foreign investment

2. boosts trade

encourages foreign investment

predictable returns attract long-term capital and FDI

boosts trade

stable exchange rates make pricing and planning easier for exporters and importers

give 2 disadvantages of fixed exchange rates

1. reserves dependency

2. trade imbalances

reserves dependency

requires large foreign exchange reserves to maintain the peg, which can deplete under economic pressure

trade imbalances

overvalued currency makes exports expensive and imports cheap, leading to persistent deficits

limited monetary policy

countries prioritise the exchange rate over domestic economic goals under fixed exchange rate systems