Merits of Flexible Exchange Rates

Flexible exchange rates refer to a system where the exchange rate of a currency is determined by the forces of supply and demand in the foreign exchange market. The exchange rate can fluctuate frequently, depending on various economic factors such as inflation, interest rates, and trade balances. One of the merits of flexible exchange rates is that it eliminates overvaluation or undervaluation of currencies.

Eliminates Overvaluation or Undervaluation of Currencies

Under a flexible exchange rate system, the exchange rate adjusts automatically to maintain equilibrium in the market. This means that if a currency is overvalued, its value will decrease in response to market forces, and if it is undervalued, its value will increase. This mechanism ensures that currencies are always trading at their true market value, without any artificial intervention from the government or central bank.

For example, if a country's economy is growing faster than its trading partners, its currency may become overvalued as demand for it increases. This can lead to a trade deficit as exports become more expensive and imports become cheaper. Under a flexible exchange rate system, the currency would naturally depreciate, making exports cheaper and imports more expensive, thus restoring balance to the trade account.

Similarly, if a country's economy is performing poorly, its currency may become undervalued as investors lose confidence in its prospects. This can lead to inflation as imports become more expensive and exports become cheaper. Under a flexible exchange rate system, the currency would naturally appreciate, making imports cheaper and exports more expensive, thus helping to control inflation.

In conclusion, flexible exchange rates have the merit of eliminating overvaluation or undervaluation of currencies. This ensures that exchange rates are always trading at their true market value, which helps to maintain balance in the economy and promote stable economic growth.