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Flexible Exchange Rate System | Meaning, Merits and Demerits

Last Updated : 16 Aug, 2023
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A medium of exchange for goods and services is called currency, which is different from one country to another country. However, a country‚Äôs currency cannot be used in another country. For this purpose, the currency of one country is converted into the currency of another country, and the rate at which one currency is exchanged for another is called the Foreign Exchange Rate. Foreign exchange rates can be classified into various types. One of them is Flexible Exchange Rate System. Flexible Exchange Rate System is determined by the forces of demand and supply of different currencies in the foreign exchange market.

What is Flexible Exchange Rate System?

Under this system, the exchange rate for the currency is fixed by the forces of demand and supply of different currencies in the foreign exchange market. This system is also called the Floating Rate of Exchange or Free Exchange Rate. It is so because it is determined by the free play of supply and demand forces in the international money market.

  • Under the Flexible Exchange Rate system, there is no intervention by the government. 
  • It is called flexible because the rate changes with the change in the market forces.
  • The exchange rate is determined through interactions of banks, firms, and other institutions that want to buy and sell foreign exchange in the foreign exchange market.
  • The rate at which the demand for foreign currency is equal to its supply is called the Par Rate of Exchange, Normal Rate, or Equilibrium Rate of Foreign Exchange.

Merits of Flexible Exchange Rate System

Some of the major advantages of a flexible exchange rate system are as follows:

1. Automatic Adjustment in BOP: One of the major advantages of the flexible exchange rate system is that the disequilibrium in BOP automatically gets corrected when there is a change in the exchange rate. In case of a BOP deficit, there will be an excess supply of domestic currency which will result in a fall in the exchange rate due to market forces of demand and supply. This fall in the exchange rate will make the export of goods cheaper (increasing exports) and the import of goods expensive (reducing imports), ultimately removing the deficit in BOP. Similarly, in case of a BOP surplus, there will be an excess demand for domestic currency which will result in a rise in the exchange rate. This increment will make the export expensive (reducing exports) and import cheaper (increasing imports), ultimately bringing the BOP to equilibrium.

2. Absorption of Sudden Shocks: Under the flexible exchange rate system, the domestic economy is not affected by external shocks and pressures. It means that there is a minimum threat of import inflation from outside the country.

3. No Collusion between Internal-External Objectives: In order to adjust a surplus or deficit in the BOP account, the fixed exchange rate system requires changes in internal policies or domestic macroeconomic policies. However, in a flexible exchange rate system, the government can adopt its own monetary policy. Simply put, under a flexible exchange rate system, to adjust a surplus or deficit in the BOP account, the government can maintain the internal balance on its own. With this, the government can also put more of its efforts into solving various internal problems such as unemployment, inflation, etc.

4. Minimum Buffer of Foreign Exchange Reserves: As the exchange rate under this system is not pegged, there is no need for the central bank of the country to hold a minimum foreign exchange reserve as a buffer against any unforeseen development in international trade.

Demerits of the Flexible Exchange Rate System

Besides its various advantages, there are a few drawbacks to the flexible exchange rate system. Some of them are as follows:

1. Uncertainty and Confusion: The flexible exchange rate system causes uncertainty and confusion in trade and investment. It means that, when the exchange rate fluctuates freely, the likelihood of uncertainty increases. For example, an Indian trader dispatches an export invoice to a US buyer without any knowledge about the price at which the foreign currency will be converted into Indian Rupees. This type of uncertainty affects trade. However, it can be reduced by using forward exchange contracts.

2. Inflationary Effect: Under a flexible exchange rate system, the chances of the inflationary effect of exchange depreciation on a country’s domestic price level are more. Besides, due to the inflationary rise in price, the external value of the currency depreciates.

3. Unnecessary Capital Movements: There is unnecessary capital movement due to fluctuating exchange rate system. This system also causes large-scale capital inflow and outflow by encouraging different speculative activities, which disturbs the economy of the country.

4. Hampers Investment: When there is an unregulated flexible exchange rate, it makes the exchange rate erratic and as a result discourages foreign investment. Besides, as the exchange rate under this system is uncertain and has an impact on the profit and loss implications of a foreign investment deal, there are chances that a country experiences decumulation of capital.

5. Adverse Effect on Economic Structure: Flexible exchange rate system has an adverse impact on the economy of a country. The flexible exchange rates causes a change in the price of exported goods and imported goods, which destabilise the country’s economy.

6. Failure of Flexible Exchange Rate System: The experience of countries under the flexible exchange rate system adopted between the two world wars was not good, making this system flop.

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