Difference Between Fixed And Floating Rate Of Exchange

Fixed exchange rates refer to the gold standard under which the rate of exchange tends to stabilise around the mint par value. Any large variation of the rate of exchange from the mint par value would entail flow of gold into or from the country. This would have the effect of bringing the exchange rate back to the mint par value. But in these days, when gold standard no longer exists, fixed rates of exchange refer to maintenance of external value of currency at a pre-determined level.

Whenever the exchange rate differs from this level, it is corrected through official intervention. For example, when IMF was instituted every member country was required to declare the value of the currency in terms of gold and US dollars (known as par value). The actual market rates were allowed to fluctuate only within a narrow margin from this level.

Flexible rate of exchange refers to the system where the exchange rate is fixed, but is subject to frequent adjustments depending upon the market conditions. Thus, it is not a free or floating rate with cent per cent flexibility, but is any system providing for adjustments as and when required.

Free or floating rates refer to the system where the exchange rates are determined by the conditions of demand for and supply of foreign exchange in the market. The rates are free to fluctuate according to the changes in demand and supply force with no restrictions on buying and selling of foreign currencies in the foreign exchange market.

A lively debate on the advisability of adopting fixed or floating rates of exchange has always been engaging the attention of economists. Forceful arguments have been put forward in favour of both the systems.

Merits of Fixed Exchange Rates. Advocates of fixed exchange rates state the following points in support of fixed exchange rates:

1. Promotion of international trade. Stable exchange rates encourage International trade by providing certainty and confidence. Exporters and importers know in advance how much they receive or they will have to pay in terms of home currency.

2. Promotion of international investment. Stable exchange rates promote international investments which are very much required for economic development and progress of the underdeveloped countries. Lenders on long term would be prompted to invest in other countries only when the return in terms of home currency is ensured by stable exchange rates.

3. Facilitating long-term planning. Firms and the Government can draw out long-range plans and work toward economic stability and prosperity easily under conditions of stable rates of exchange.

4. Development of currency areas. Proper functioning of regional arrangement like sterling area or dollar area would be facilitated with the stable rates of exchange. In such arrangements if flexible rates prevail, especially for the major currency like pound-sterling or dollar, with which the other currencies are linked, it will have serious repercussions on many other currencies.

5. Prevention of speculation. Stable exchange rates avoid the dangerous possibilities of speculation and thus help in orderly growth of international markets.

Merits of Flexible/Floating Exchange Rates.

Advocates of flexible exchange rates put forward the same arguments as that suggested for fixed exchange rates. They counter the claims made for fixed exchange rates.

1. Promotion of international trade. The post-war experiences do not support the view that stable rates of exchange are required for smooth flow of international trade. Even under flexible rates of exchange international trade will flourish. So long as the balance of payments is at equilibrium, no change in the rate of exchange is expected. When the balance of payments is in disequilibrium, the rate of exchange will change but the change expected can be assessed. Further, the importers and exporters can guard themselves against the changes by entering into forward contracts.

2. Promotion of international investment. The claim that stable exchange rates promote international investment is not borne out by facts. Even under fixed exchange rates it cannot be ensured that the rates will not change over a long period running into decades. The impending fear of the possibility of devaluation of the currency may act as a deterrent factor in international investments. On the other hand, flexible exchange rates adjust the external value of the currency and prevent recurrence of balance of payn ents crises more effectively. As a result, their effect on the international lending is likely to be beneficial.

3. Facility of long-range planning. Under flexible exchange rates, the adjustment of balance of payments is done through changes in the rate of exchange without affecting the domestic prices and income. This helps planning by firms. Further, flexible rates allow freedom to the currency in its monetary arrangements.

4. Development of currency areas. The argument that stable rates of exchange are required for development of regional arrangements does not stand the proof. The case of sterling area is a good illustration in this regard. Thr sterling area was promoted in 1930s at which time the pound-sterling was free to fluctuate under market conditions. Therefore, it is dear that the strength of the sterling area lies in certain economic, political and social factors which have bound them rather than the exchange rates. Allowing the pound-sterling to fluctuate freely would not weaken the area if the decision is taken after consultation with member countries.

5. Prevention of speculation. It is claimed that stable exchange rates would prevent speculation. But the fact is otherwise. By keeping the value of the currency at an artificial level, it encourages speculation of devaluation of the currency. The suspicion of devaluation will ultimately make devaluation inevitable and result in the destruction of the stability of the currency.

Further, it is pointed out that the stable exchange rates do not reflect the present and true cost prices. When countries follow different economic policies, the cost price relationship alters frequently. Flexible exchange rates take care of these. They provide automatic adjustment for the balance of payments disequilibria.

But it cannot be denied that fluctuation of rates widely is not conducive to smooth functioning of the world economy. Especially in times of inflation, the flexible rates of exchange cause a vicious circle of deflation and inflation. Both the systems of exchange rates have their own merits and demerits. Neither of the systems in the extreme form is good. What is required is a system which is fairly stable but at the same time flexible enough to accommodate small changes in accordance with the needs. The system now prevalent under IMF is a managed float in which exchange rates of major currencies are floating but subject to exchange control regulations to keep the exchange rate movements within limits.

External Value of Rupee

Since September 1975, value of the rupee was being determined on the basis of a ‘basket of currencies’. Sterling was used as the intervention currency in terms of which external value of the rupee was fixed. The rupee-sterling middle rate was so fixed that the value of the rupee in terms of the basket was within a band of 5% of the base rate, i.e., rate announced for rupee on switching over to the system. With effect from March 1992, US dollar was adopted as the intervention currency in place of sterling and rupee was partially floated. 40% of the inward remittances on current account were converted at the official rate which was the rate based on the Reserve Bank rate for the foreign currency concerned. 60% of the remittances were converted at market rate which was derived on the basis of market forces of demand and supply for the currency concerned.

The external value of the rupee was made fully dependent on market forces with effect from March 1993. The official rate has been abolished. The exchange rate for rupee is now calculated based on the market rates. The Reserve Bank announces a reference rate for US dollar at which it is willing to buy that currency. The external value of rupee is therefore floating, subject to ceiling determined by the Reserve Bank rate.

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