Question

Advantages of flexible exchange rate over fixed exchange rate

Answer 1

Advantages:

(i) Automatic Adjustment in BOP:

The chief merit of the freely fluctuating exchange rate is that the BOP disequilibrium gets corrected automatically with the change in exchange rate.

If a BOP deficit arises, there would be an excess supply of home currency leading to a fall in exchange rate simply by the market forces of demand and supply. This causes export goods cheaper and import goods dearer.

(ii) No Collusion Between Internal-External Objectives:

Surplus and deficit in the BOP accounts get corrected if foreign exchange rate falls and rises, respectively. In a regime of fixed exchange rate, the removal of BOP deficit requires the adoption of internal policies like fall income and price level. In other words, pegged exchange rate requires a change in domestic macroeconomic policies like deflationary policies of price and output reduction.
(iii) Absorption of Sudden Shocks:

In a flexible exchange rate, the domestic economy remains insulated from external shocks and pressures. Under this system, the threat of ‘importing inflation’ from outside the country is minimum. In other words, price feedback effect is imperceptible.

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Answer 2

Advantages:

(i) Automatic Adjustment in BOP:

The chief merit of the freely fluctuating exchange rate is that the BOP disequilibrium gets corrected automatically with the change in exchange rate.

If a BOP deficit arises, there would be an excess supply of home currency leading to a fall in exchange rate simply by the market forces of demand and supply. This causes export goods cheaper and import goods dearer.

(ii) No Collusion Between Internal-External Objectives:

Surplus and deficit in the BOP accounts get corrected if foreign exchange rate falls and rises, respectively. In a regime of fixed exchange rate, the removal of BOP deficit requires the adoption of internal policies like fall income and price level. In other words, pegged exchange rate requires a change in domestic macroeconomic policies like deflationary policies of price and output reduction.

(iii) Absorption of Sudden Shocks:

In a flexible exchange rate, the domestic economy remains insulated from external shocks and pressures. Under this system, the threat of ‘importing inflation’ from outside the country is minimum. In other words, price feedback effect is imperceptible.