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Pros and Cons of Fixed Exchange Rates

As a professional, you must have come across the terminology, ‘Fixed Exchange Rate”. In the finance world, as beneficial as the term is, it can sometimes be complex when managing finances.

In economics, the fixed exchange rate is defined as the value of currency tied to the value of a commodity that is widely used, such as gold. Today, most fixed exchange rates are tied to the dollar.

For instance if the exchange rate is US $1=€1 Euro then this conversion rate would stay the same unless the gold price changes. Most of the fixed exchange rates these days are pegged to the US Dollar because the dollar is considered as a reserve currency globally.

Keen to learn more of how the exchange rates work? Go through the article.

Getting To Know The History

Previously, the currencies were fixed to the ounce of gold.

 In 1944, all currencies were pegged to the US Dollar as a mutual agreement between all countries, the Bretton Woods Agreement. With this decision, the United States redeemed all dollars for ounces of gold.

Pros and Cons of Fixed Exchange Rates

 

To end the recession, back in 1971, President Nixon detached the dollar from the set gold standard which marked the end of a hundred year history.

Now that you are aware of the history briefly, let’s get to know the advantages and disadvantages of fixed exchange rates.

Advantages of Fixed Exchange Rates

1.   Minimizing the Risk and Uncertainty Factor

One factor that is crucial to the success of a stable and steady growth in trade requires a fixed exchange rate. Unexpected fluctuations in exchange rates raises concerns for importers and exporters with respect to their plans.

When the exchange rate fluctuates it causes disruption in the incomes of exporters and the cost incurred by the importers. This issue regarding the uncertainty can only be addressed with the fixed exchange rate methodology.

2.   Eliminating Speculation in the Foreign Market

Keeping the exchange rate stable for longer duration can deter speculation in the foreign exchange market since people anticipate that the rate would remain the same in the near future.

Also, this stability over longer periods discourages the flight of capital. By fixing the exchange rate traders have confidence in the trades and that their respective international payments would be made safely without any losses.

3.   Preventing the Currency Depreciation

In underdeveloped countries, BOP issues are permanent. Instability in the exchange rates tends to fuel the BOP crisis such as continuously depreciating currency in the home country.

 

In a nutshell, fluctuating exchange rates lead to depreciation in currencies.

4.   Adopting Macroeconomic Policies Responsibly

A fixed exchange rate would prevent devaluation of currency since the stability would discourage the government from adopting any macro-economic policies irresponsibly.

Also, a fixed exchange rate system would help deflationary policies to cover the BOP deficit without altering the domestic policies.

Disadvantages of Fixed Exchange Rates

1.   Encouraging Speculation

While under a fixed exchange rate, if a country is faced with a big BOP deficit, the chances of speculation are high and bright, they get boosted.

If the persistence of the BOP deficit is expected in the near future, the authorities can opt for cutting down on the foreign exchange rates. This methodology encourages people to trade domestic currencies in the foreign exchange market.

2.   Holding Foreign Exchange Reserves Adequately

In order to implement a stable exchange rate effectively, it is necessary to hold foreign exchange reserves adequately. Maintaining such an adequate volume is challenging in the underdeveloped countries.

Back in the 1970s the fixed exchange rate continued because of the low global trade volume and low foreign exchange reserves volume.

3.   Harsh Internal Measures Lead to Contracting Economies

When faced with disequilibrium in the BOP, the foreign exchange reserves go down resulting in devaluation of currencies leading to strict internal measures  in order to reduce the deficits.

Fixed Exchange Rates

 

Taking such harsh internal measures into account leads to contracting economies resulting in fallouts such as increase in unemployment rates and increase in prices.

4.   Bypassing the International Competitive Environment

Under the fixed exchange rates, the continuous changes taking place in the international competitive environment are not reflected.

To make a strong footing of the home product in the international market, the domestic economic policies need to change. This way, the country’s export products have a noticeable presence in the foreign market.

In simple words, when the exchange rate is fixed, it takes the gloss out of the international competitive environment.

The Final Word

In the financial world, the understanding and implementation of fixed exchange rates is complex.

This article outlines the numerous advantages and disadvantages that come with fixing the exchange rate that would help decide how they will impact the operations of your business.

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