Question

2.5 Fixed Versus Flexible. What are the advantages and disadvantages of fixed exchange rates?

Answer 1

The advantages of fixed exchange rates are :

• Frequent fluctuations in the exchange rate do not occur
• Stable exchange rates lead to higher investments as uncertainty is lower
• Speculation in exchange rates leading to instability and capital flight is reduced
• Helps rein in inflation as imported goods are not allowed to become more expensive

The disadvantages of fixed exchange rates are :

• It is difficult and complex to reconcile macroeconomic objectives such as interest rates, monetary policy, inflation etc.
• More rigid in nature as short-term adjustments to exchange rates cannot happen in response to macroeconomic factors
• The "correct" exchange rate is difficult, complex and subjective to determine
• Results in imbalances in current accounts and balance of payments
• Foreign exchange reserves may not be adequate to maintain the fixed exchange rate