Question

What are the strong and weak points of the flexible exchange rate system? What are the strong and weak points of the fixed exchange rate system?

Short answer

The strong points of a flexible exchange rate system include independent monetary policy and market efficiency. Its weak points are volatility and competitiveness. The fixed exchange rate system brings stability and predictability, but lacks monetary policy independence and can lead to instability if the fixed rate is not maintained successfully.

Step-by-step solution

Understanding the Flexible Exchange Rate System

In a flexible exchange rate system, the value of the currency is determined by the foreign exchange market through supply and demand dynamics. When demand for a country’s currency is high, its value increases. Conversely, if demand is low, its value decreases. Government or central bank usually doesn't intervene in the foreign exchange market.

Identifying the Strong and Weak Points of the Flexible Exchange Rate System

The strong points of this system include: Independent monetary policy which allows country to adapt to the economic shocks and conditions; and market efficiency as the rate balances itself out due to market forces. The weak points include: Volatility, which may lead to financial uncertainty; and competitiveness, as a strong currency can make exports expensive, possibly leading to trade deficits.

Understanding the Fixed Exchange Rate System

In a fixed exchange rate system, the value of the currency is pegged or fixed to another currency or a commodity like gold. The central bank maintains this rate by buying or selling its own currency on the foreign exchange market in exchange for the currency to which it is pegged.

Identifying the Strong and Weak Points of the Fixed Exchange Rate System

The strong points include: Stability, which encourages international trade and investments; and predictability, providing certainty for businesses engaging in international trade. However, there are also weak points: Lack of monetary policy independence which can limit the country's ability to handle domestic economic issues; and potential for economic instability if the fixed rate is not maintained successfully and has to be devalued abruptly.