Disadvantages of Fixed Exchange Rate System

First, this system deprives the government of its monetary independence (Gillespie, 2014). The system requires monetary authorities to pursue the monetary policy of contraction and expansion to maintain exchange rate stability. For instance, a country will correct its exchange rate instability by buying or selling foreign exchange reserves or controlling the country’s money supply. Therefore, if the monetary authorities want to protect fixed exchange rate, they will have to sacrifice objectives of monetary policy. Second, fixed exchange rate system has problems with reserves. For a country to protect the fixed exchange rate, it must have large foreign exchange rate reserves (Gillespie, 2014). Therefore, monetary authorities will have heavy burden regarding the management of foreign exchange reserve. Precisely, there can be international liquidity problem.

Third, fixed exchange rate system is vulnerable to speculative attacks. In situations when the foreign exchange markets speculate about revaluation or devaluation, then the government will find it hard to fight such speculations. The government will incur a significant amount of their foreign exchange reserves trying to fight speculations. Lastly, under fixed exchange rate regime, the economy may experience the problem of responding to shocks (Gillespie, 2014). On the same note, the government may lack the mechanisms to respond immediately to the problems in the balance of payment.

In a fixed exchange rate regime, the government intervenes in foreign exchange markets to determine exchange rates (Hubbard, Garnett & Lewis, 2012). The government’s role is to fix the values of the exchange rate at particular levels (Hubbard, Garnett & Lewis, 2012). The government fixes exchange rates by buying or selling their currency in the foreign exchange market or by instructing the public to use officially designated rate when exchanging domestic for foreign currency.

Disadvantages of Floating Exchange rate system

The first limitation is that the system has a higher volatility. A volatile exchange rate results in uncertainty in export and import prices and this may discourage the growth of trade and foreign investments (Gillespie, 2014). The unpredictability of floating exchange rate makes international trade riskier, and this increases the cost of doing business with other nations. Moreover, under this system, it is hard for the macroeconomic fundamentals to explain short-run volatility. Second, in floating exchange rate system, the market may fail to determine the appropriate exchange rate. Due to inaccurate results from the system, there would be a misallocation of resources. Third, floating exchange rate is prone to speculation (Shailaja, 2008). The day-to-day fluctuation in exchange rates enhances speculations in the market, which that cause harm to export and import competing sectors. Lastly, the system reduces the investments in a country. The high volatility and uncertainty due to floating exchange rates discourage investment by multinational companies.

In a floating exchange rate regime, market forces of demand and supply determines exchange rates (Hubbard, Garnett & Lewis, 2012). The central bank has an obligation to follow a simple set of rules. They do not influence exchange rates levels.

Disadvantages of Pegged Exchange Rate System

First, this system creates an environment that requires huge foreign currency reserves. Therefore, the system requires the government to have large foreign exchange reserves at its disposal to maintain rates. Large foreign exchange reserves come with opportunity costs that are expensive to the country (Gillespie, 2014). Second, pegged exchange rate system allows transmission of shock from the anchor country. With this system, there will be an easy transmission of shocks to the pegging country. This would result in negative consequences since there is no chance for devaluation when the country has fixed exchange rate. Third, a pegged exchange rates system leads to loss of control over monetary policy and the government’s intervention to maintain the rigid peg (Shailaja, 2008). The consequence of such a scenario is that the central bank will either accumulate large foreign exchange reserves or drain them.

The government or the central bank determines a pegged exchange rate. The government fixes an official exchange rate to a foreign currency. Similarly, the government might decide to fix the official currency to the price of gold.

References

Gillespie, A. (2014). Foundations of economics. Oxford: Oxford University Press.

Hubbard, G., Garnett, A., & Lewis, P. (2012). Essentials of economics. Pearson Higher Education AU.

Shailaja, G. (2008). International finance. Hyderabad, India: University Press (India).

 
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