Question

What is flexible exchange rate? What are its merit and demerits? 2?

Answer 1

Merits of Flexible Exchange Rates System:

Under the flexible exchange rate system, exchange rate between different currencies, like the prices of commodities are freely determined by market forces, that is, by demand and supply forces.

With the change in economic conditions underlying demand and supply, the exchange rate will automatically change without any intervention by the Government. That is why, it is called flexible or variable exchange rate system.

1. Problems of Undervaluation and Overvaluation are Avoided:

The advocates of flexible exchange rates contend that under it the problems of undervaluation and overvaluation of currencies which are found in the fixed exchange rate system are avoided. Whenever there is deficit in balance of payments implying overvaluation of the national currency under the flexible exchange rates, it will depreciate (that is, its value will fall) which on the one hand will make exports cheaper and thereby encourage them and on the other will make the imports costlier than before which will tend to discourage them. Thus, increase in exports and decline in imports as a result of depreciation will lead to the automatic correction in the balance of payments.

2. Promotes Growth of Multilateral Trade:The advocates of flexible exchange rates system are strongly of the view that as unlike fixed exchange rates system, this does not create serious and difficult problems, it will ensure rapid growth of multilateral world trade. Further, they point out that promotion of world trade under the flexible exchange rates would not interfere in any way the adoption of policies to achieve domestic economic stability.

3. Flexible Exchange Rates does not Necessarily Show Large Fluctuations:

It has been pointed out in defence of the flexible exchange rates that the problems of undervalued or overvalued currency found under the fixed exchange rate regime are not found in the flexible exchange rate system. Further, it is contended that exchange rates being flexible does not necessarily mean there will be large fluctuations in them. Even under flexible exchange system there need not be large fluctuations in exchange rates.

Demerits of Flexible Exchange Rate System:

1. Flexible Exchange Rates Create a Situation of Instability and Uncertainty:

An important argument against flexible exchange rates is that too frequent fluctuations in exchange rate under it create uncertainty about the exact amount of receipts and payments in foreign exchange transac­tions. This instability hampers foreign trade and capital movements between the countries.

. Dampening Effect on Foreign Trade:

Under the flexible exchange rates, the price of for­eign exchange or international value of the national currency is quite uncertain. As a result, they are unable to take proper decisions regarding exports and imports of goods. Obviously, this has a damp­ening effect on the volume and growth of foreign trade.

3. Widespread Speculation with a Destabilising Effect:

The system of flexible exchange rates has been opposed on the ground that under it there is widespread speculation regarding ex­change rates of currencies which has a large destabilising effect on these rates. Friedman, on the other hand, contend that speculation has a stabilising influence on exchange rates. However, whether or not speculation has a destabilising or stabilising effect is a highly controversial issue in economics which has so far remained unresolved.4. Provides an Inflationary Bias to an Economy:

Another shortcoming of the flexible, ex­change rates is that they have an inflationary impact on the economy. It has been pointed out that whenever due to deficit in balance of payments, the currency depreciates, the prices of imports go up. The higher prices of imported materials raise the prices of industrial products and thus generate cost-push inflation.

Answer 2

Answer:

Flexible exchange rate is a float rate of exchange , determined by the supply of and demand for different currencies . It is also called free exchange rate as it determined by the free play of supply and demand forces in the international money market.