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What are the advantages and disadvantages of a fixed exchange rate system?

What are the advantages and disadvantages of a floating exchange rate system?

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Solution Summary

The solution explains the fixed and floating exchange rate system in detail.

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Arguments in Favour of a Fixed Rate:
1. Reduced risk in international trade - By maintaining a fixed rate, buyers and sellers of goods internationally can agree a price and not be subject to the risk of later changes in the exchange rate before contracts are settled.
2. Introduces discipline in economic management - As the burden or pain of adjustment to equilibrium is thrown onto the domestic economy then governments have a built-in incentive not to follow inflationary policies.
3. Fixed rates should eliminate destabilising speculation - Speculation flows can be very destabilising for an economy and the incentive to speculate is very small when the exchange rate is fixed.

Disadvantages of the Fixed Exchange Rate:
1. No automatic balance of payments adjustment - A floating exchange rate should deal with a disequilibrium in the balance of payments without government interference, and with no effect on the domestic economy.
2. Large holdings of foreign exchange reserves required - Fixed exchange rates require a government to hold large scale reserves of foreign ...

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