What is Flexible Exchange Rate? And its Advantage and Disadvantages.
Flexible exchange rate means an exchange rate which is determined by demand for and supply of foreign exchange. Thus, there is no intervention by Central Bank and value of currency is allowed to adjust freely. The foreign exchange market is busy at all times by changes in the exchange rates.
Flexible Exchange Rate Advantages.
- Flexible exchange rates eliminate the need for central banks to hold international reserves.
- Flexible exchange rates are helpful to do away with barrier to trade and capital movements.
- Flexible exchange rate enhances the efficiency in the economy by achieving optimum: resources allocation.
- Flexible exchange rate may encourage stabilizing speculation, which limits the size of exchange rate fluctuations.
- Flexible exchange rates facilitate domestic economic autonomy by removing external constraint on balance of payment equilibrium.
Flexible Exchange Rate Disadvantages.
- The temporary or cyclical exchange rate stability will transmit price instability which may discourage trade and, hence, reduce economic welfare. The more elastic the demand and supply of foreign exchange, the greater will be exchange rate volatility.
- Destabilizing speculation may increase volatility by pushing exchange rate progressively farther.
- The absence of balance of payments constraints might foster the pursuit of domestic economic policies inimical to long run maximization.
According to purchasing power parity theory, under the flexible exchange rate system, the rate at which currency of home country will depreciate, will be equal to the difference between the home country’s inflation rate and the inflation rate in the rest of the world. After the currency of home country depreciation, the currency of importable rise relative to the currency prices of exportable causing a depreciation in the commodity terms of trade.