Answer to Question #295476 in Marketing for jean

Question

How will you differ fixed exchange rate from a flexible exchange rate? What are the roles of these exchange rate systems in International Trade?

Answer 1

Fixed exchange rate system is referred to as the exchange system where the exchange rate is fixed by the government or any monetary authority. If the rate of exchange diverges from the fixed equilibrium level due to market forces or the activities of speculators, the monetary authority or government interferes in the foreign exchange market and maintains the rate of exchange at the equilibrium level. In a flexible exchange rate system, the value of the currency is allowed to fluctuate freely as per the changes in the demand and supply of the foreign exchange. The flexible exchange rates are determined by the free working of the market forces. If there is an excess of demand for foreign currency over its supply, the foreign currency appreciates whereas the home currency depreciates. On the other hand, when the supply of foreign currency exceeds the demand for it, the foreign currency depreciates and the exchange value of home currency appreciates in terms of the foreign currency.

The exchange rates play an important role in a country's trade performance. Whether determined by exogenous shocks or by policy, the relative valuations of currencies and their volatility often have important repercussions on international trade, the balance of payments and overall economic performance. Exchange rates are often used by companies and the public for annual financial statements, tax returns, statistical reports and economic analysis. Exchange rates do have implications for price stability and growth. For instance, exchange rates affect prices in international trade. 

The main economic advantages of flexible exchange rates are that they leave the monetary and fiscal authorities free to pursue internal goals such as full employment, stable growth, and price stability and exchange rate adjustment often works as an automatic stabilizer to promote those goals. The main economic advantage of fixed exchange rates is that they promote international trade and investment, which can be an important source of growth in the long run, particularly for developing countries. The advantages of flexible compared to fixed exchange rates for any given country depends on how interdependent that country is with its neighbors. If a country’s economy is highly reliant on its neighbors for trade and investment and experiences economic shocks similar to its neighbors’, there is little benefit to monetary and fiscal independence, and the country is better off with a fixed exchange rate. If a country experiences unique economic shocks and is economically independent of its neighbors, a flexible exchange rate can be a valuable way to promote macroeconomic stability. A political advantage of a currency board or currency union in a country with a profligate past is that it restricts the monetary and fiscal authorities, making it harder to finance budget deficits by printing money.