Question

Write in brief two merits and two demerits of Fixed Exchange Rate.

Hint:

The fixed exchange rate system provides stability but comes at the cost of flexibility and high reserves.

Answer 1

Step 1: Understand Fixed Exchange Rate.
A fixed exchange rate system is one where the value of a country's currency is pegged to another major currency (like the US Dollar or Euro) or a basket of currencies. The government or central bank intervenes to maintain the fixed rate.

Step 2: Merits of Fixed Exchange Rate.
- **Stability in International Trade:** A fixed exchange rate provides certainty for businesses and traders as they can easily predict the costs of transactions across borders.
- **Prevention of Inflation:** With a fixed exchange rate, the country's currency is less likely to devalue, which helps in controlling inflation.

Step 3: Demerits of Fixed Exchange Rate.
- **Requires Large Reserves:** A fixed exchange rate requires a country to maintain large foreign exchange reserves to maintain the pegged rate.
- **Limited Flexibility:** A country loses flexibility in adjusting its monetary policy to suit domestic economic conditions since it must maintain the fixed exchange rate.