Fixed Exchange Rate System Essay

Introduction

In the world of economics there is a wide variety of different types of exchange rate systems in the foreign exchange market. The two main types of systems are the Flexible Exchange Rate also known as a Floating Exchange Rate and the Fixed Exchange Rate also known as a Stable Exchange Rate (1). A Flexible Exchange Rate is defined as being an exchange rate which constantly fluctuates depending on the supply and demand of a currency in relation to other currencies in the foreign exchange market (2). Under this system, without intervening, the central bank lets the exchange rate adjust so as to equate the demand and supply for foreign currency (1). For example, if there is a high demand for Malaysian Ringgit its exchange rate

A Fixed Exchange Rate occurs when the government or monetary authority (central bank) seeks to keep the value of its currency fixed against another, for example, the value of the British Pound to the Euro is firmly set at £1 = €1.1 (3). Under this system, foreign central banks stay ready to buy and sell their currency at a stable price. This system was used under the Gold Standard System where each country dedicated itself to freely change its currency into gold at a fixed price. This is known as mint par value of exchange. In July 1994, an agreement was reached and the Fixed Exchange Rate system prevailed in the world (1). Both types of exchange rate systems have their advantages and disadvantages, and the choice of which one to adopt may differ with every country depending on their

The main disadvantage of Flexible Exchange Rates is their excessive volatility with the exchange rates (currency value) being larger and changing more frequently than the fundamentals suggest (6). This volatility creates abundant instability and uncertainty in the international market; both long-term foreign and local investments greatly reduce as it becomes more difficult to assess exact levels of return and risk involved. For example, as businesses plan for the future, with the constant changing prices exporters won’t be sure how much money they will make from overseas sales, likewise, importers won’t know how much it will cost them to bring in a certain amount of foreign goods (5). The use of Flexible Exchange Rates do not always adjust themselves to automatically eliminate balance of payment deficits, it actually worsens existing levels of inflation. In cases when import and export price elasticity of demand is very low (less than one) the foreign exchange market becomes unstable, resulting in the depreciation of weak currencies worsening the balance of payment deficit even more (4). The Flexible Exchange Rate system can have great negative inflationary effects as import prices rise and exchange rate falls. For example,