Critically examine the relative merits and demerits of the fixed and flexible exchange rates.

Fixed exchange rates

Advantages of fixed exchange rates

Certainty - with a fixed exchange rate, firms will always know the exchange rate and this makes trade and investment less risky.

Absence of speculation - with a fixed exchange rate, there will be no speculation if people believe that the rate will stay fixed with no revaluation or devaluation.

Constraint on government policy - if the exchange rate is fixed, then the government may be unable to pursue extreme or irresponsible macro-economic policies as these would cause a run on the foreign exchange reserves and this would be unsustainable in the medium-term.

Disadvantages of fixed exchange rates

The economy may be unable to respond to shocks - a fixed exchange rate means that there may be no mechanism for the government to respond rapidly to balance of payments crises.

Problems with reserves - fixed exchange rate systems require large foreign exchange reserves and there can be international liquidity problems as a result.

Speculation - if foreign exchange markets believe that there may be a revaluation or devaluation, then there may be a run of speculation. Fighting this may cost the government significantly in terms of their foreign exchange reserves.

Deflation - if countries with balance of payments deficits deflate their economies to try to correct the deficits, this will reduce the surpluses of other countries as well as deflating their own economies to restore their surpluses. This may give the system a deflationary bias.

Policy conflicts - the fixed exchange rate may not be compatible with other economic targets for growth, inflation and unemployment and this may cause conflicts of policies. This is especially true if the exchange rate is fixed at a level that is either too high or too low.

Flexible Exchange Rates 

Advantage of Flexible Exchange Rates

Flexible exchange rate system is claimed to have the following advantages:

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