What Are The Disadvantages Of Flexible Exchange Rates?

Flexible exchange rate system is claimed to have the following: Flexible Exchange Rates Create a Situation of Instability and Uncertainty. An important argument against flexible exchange rates is that too frequent fluctuations in exchange rate under it create uncertainty about the exact amount of receipts and payments in foreign exchange transac­tions. This instability hampers foreign trade and capital movements between the countries. Dampening Effect on Foreign Trade: Under the flexible exchange rates, the price of foreign exchange or international value of the national currency is quite uncertain. As a result, they are unable to take proper decisions regarding export and import of goods. Obviously, this has a dampening effect on the volume and growth of foreign trade. Widespread Speculation with a Destabilising Effect: The system of flexible exchange rates has been opposed on the ground that under it there is widespread speculation regarding exchange rates of currencies which has a large destabilising effect on these rates. Provides an inflationary bias to an economy: Another shortcoming of the flexible exchange rates is that they have an inflationary impact on the economy. It has been pointed out that whenever due to deficit in balance of payments, the currency depreciates, the prices of imports go up. The higher prices of imported materials raise the prices of industrial products and thus generate cost- push inflation.

I agree with Mr. Xavier L., but I would like to add some points: Factor Immobility: The immobility of various factors of production deprives the flexible exchange rate system of its advantages arising from the adoption of monetary and other policies for maintaining internal stability. Such policies produce desirable effects on production and employment only when supply of factors of production is elastic.Failure of Flexible Rate System: Experience of the flexible exchange rate system adopted between the two world wars has shown that it was a flop.

Thank you for your question, Valerii. Disadvantage of Flexible Exchange Rates : The following are the main drawbacks of the system of flexible exchange rates Low Elasticities: The elasticities in the international markets are too low for exchange rate, variations to operate successfully in bringing about automatic equilibrating adjustments. When import and export elas­ticities are very low, the exchange market becomes unstable. Hence, the depreciation of the weak currency would simply tend to worsen the balance of payments deficit further. Unstable conditions: Flexible exchange rates create conditions of instability and uncertainty which, in turn, tend to reduce the volume of international trade and foreign investment. Long-term foreign investments arc greatly reduced because of higher risks involved. Adverse Effect on Economic Structure: The system of flexible exchange rates has serious repercussion on the economic structure of the economy. Fluctuating exchange rates cause changes in the price of imported and exported goods which, in turn, destabilise the economy of the country. Unnecessary Capital Movements: The system of fluctuating exchange rates leads to unnecessary international capital movements. By encouraging speculative activities, such a system causes large-scale capital outflows and inflows, thus, seriously disturbing the economy of the country. Depression Effects of Capital Movements: Speculative capital movements caused by fluctuating ex­change rates may lead to the problem of extremely high liquidity preference. In a situation of high liquidity preference, people tend to hoard currency, interest rates rise, investment falls and there is large-scale unemployment in the economy. Inflationary Effect: Flexible exchange rate system involves greater possibility of inflationary effect of exchange depreciation on domestic price level of a country. Inflationary rise in prices leads to further depreciation of the external value of the currency.