Flexible Exchange Rate

Flexible Exchange Rate

 

In this system exchange rate go on fluctuating according to the demand and supply of it in the world market. Exchange rate is determined according to the free forces of demand and supply of foreign currencies.

MERITS:-

1. Freely determined:- This system is quite simple. The exchange rate changes freely to equate demand and supply and the problem of scarcity or surplus is automatically solved.
2. 
   Smooth adjustment:- Flexible exchange rate bring smooth adjustment in BOP position automatically. When there is deficit in the BOP, the external value of the currencies fall. It encourages export and discourages imports and thus automatically brings equilibrium in the BOP.
3. 
   Full employment:- Flexible exchange rates reflect the true cost-price structure relationship. They are more suitable to countries seeking to follow a policy a full employment.
4. 
   Growth of multilateral trade:- Flexible exchange rate promotes free trade. It does not require the use of exchange control which may be necessary under the fixed exchange rate system. It is good under the multilateral trade system. Like fixed exchange rate, it does not create serious problem. It will ensure rapid growth of multilateral world trade.
5. 
   Avoids prolonged Disequilibrium:- The flexible exchange rate system facilitates continues adjustments. So a prolonged disequilibrium is automatically avoided. It helps government to get rid of BOP deficit problem. As has been seen above, the fixed exchange rates system leads either to deficit or surplus in BOP. Under this system the Government remains preoccupied with the questions of devaluation or revaluation of their currencies.
6. 
   Liquidity problem:- As exchange rate moves freely, there is no need to maintain large scale reserves. The flexible exchange rate system solves the problem of international liquidity automatically.

DEMERITS:-

1. Unsuitable:- This exchange rate is unsuitable if the factors are immobile. It is also not good during the war situation and political instability.
2. 
   BOP problem:- Due to uncertainty in the rates, elasticity‘s of demand also get affected in the foreign market. It leads to BOP problems in the country if the value of currencies rise externally.
3. 
   Inflationary:- This exchange increase in inflationary pressures on the domestic price level causing further depreciation. On the other hand, the fixed exchange rate system prevents inflation and maintains the external value of currency. It has been pointed out that whenever due to deficit in BOP, the currency depreciates the prices of imports go up. The higher prices of imported materials raise the prices on industrial products and thus generate cost-push inflation.
4. 
   Instability and uncertainty:- The flexible exchange rates lead to instability and uncertainty. This reduce the volume of investments and international trade. Due to increasing risks, long-term investments are curtailed. This instability hampers foreign trade and capital movements between the countries.
5. 
   Speculation:- Under this exchange system there will be more speculation causing further fluctuations. Due to uncertainty of changing in exchange rate more importance is given on the functions of foreign exchange market like Hedging, Speculation and Arbitrage.