Demerit of Flexible Exchange Rate:
Flexible exchange rates, also known as floating exchange rates, refer to a system where the value of a currency is determined by market forces such as supply and demand. While flexible exchange rates offer several advantages, they also have a demerit:
1. Creates Instability: One of the main demerits of flexible exchange rates is that they can create instability in the economy. This instability arises due to the fluctuations in exchange rates, which can be sudden and significant. The following factors contribute to this instability:
- Speculative Attacks: Flexible exchange rates make it possible for speculators to take advantage of currency fluctuations and engage in speculative attacks on a country's currency. Speculative attacks can lead to sharp depreciation or appreciation of the currency, causing instability in the economy.
- Inflationary Pressures: Flexible exchange rates can result in inflationary pressures as changes in exchange rates affect the prices of imported goods and raw materials. A sudden depreciation of the currency can lead to increased import costs, which can then be passed on to consumers in the form of higher prices.
- Uncertainty for Businesses: Fluctuating exchange rates introduce uncertainty for businesses engaged in international trade. The unpredictable nature of exchange rate movements can make it challenging for companies to plan and make informed decisions regarding imports, exports, and foreign investments.
- Effect on Investment: Volatile exchange rates can deter foreign direct investment (FDI) as investors may be reluctant to invest in countries with uncertain currencies. This can have a negative impact on economic growth and development.
It is important to note that while flexible exchange rates may create instability, they also provide benefits such as automatic adjustment to external shocks and the ability to maintain competitiveness. The choice between flexible and fixed exchange rates depends on the specific circumstances and objectives of a country's monetary policy.