What is the fixed exchange rate and flexible exchange rate

Fixed exchange rate- In this type of the exchange rate, the exchange rate of officially fixed by the government or the monetary authority of the country.

There are 2 types of fixed exchange rates:

a. Gold standard system: In this system, gold is considered as the common unit among the currencies of different countries. Each country has to define the value of its currency in terms of gold.

b. Bretton Wood system: In this system, all the currencies are pegged in terms of the dollar. It gave rise to the International Fund or IMF as the center of all the financial institutions of the world.

Merits:

● It leads to stability in the exchange rate.

● It attracts foreign capital.

● It has no scope for speculation.

● It promotes international trade and capital movement.

● It keeps a check on inflation

● It ensures the demand and supply of inflation.

Demerits:

● It does not support the concept of a free market.

● It may lead to overvaluation or undervaluation of the currency.

● There is no scope for automatic adjustment of the balance of payment.

● There is a need to hold foreign reserves.

Fixed exchange rate- In this type of the exchange rate, the exchange rate is determined by the forces of demand and supply of different currencies in the foreign exchange rate market. The value of the currency is allowed to fluctuate.

Merits:

● It avoids the overvaluation or undervaluation of the currency.

● There is an automatic adjustment of the balance of payment.

● There is no need to hold foreign reserves.

● It improves the efficiency of resource allocation.

● It promotes venture capital in the form of foreign exchange.

Demerits:

● It leads to speculation.

● It leads to market instability.

● It discourages international trade and investment.