Demerits of Fixed Exchange Rate System

Besides its various advantages, there are a few drawbacks to the fixed exchange rate system. Some of them are as follows:

1. Encourage Speculation: It is possible to have uncertainty and speculation under the fixed exchange rate system. If a country with a fixed exchange rate system faces a huge BOP deficit, then there is a possibility of speculation. If the speculators guess that the BOP deficit with continue to exist in the future too and the authorities may make a cut in the foreign exchange rate, then they will try to sell the domestic currency in the foreign exchange market. And, if this sale continues for a long time period, then the Central Bank will be forced to reduce the exchange rate. 

In this situation, the speculators keep on purchasing the home currencies where the exchange rates have declined, allowing these people to earn a profit. An example of the effect of such speculation is the collapse of the Bretton Woods System of the IMF in 1971.

2. Bypass International Competitive Environment: Another disadvantage of the fixed exchange rate system is that it does not reflect any continuous change in the international competitive environment.

3. Adequacy of Foreign Exchange Reserves: To have an effective and stable exchange rate, it is essential to have the adequacy of holding foreign exchange reserves which is a difficult task for poor developing countries. Therefore, it is not an adequate exchange rate system for small and developing countries.

4. Sacrifice of Internal Objectives of Growth: In order to maintain and control the fixed exchange rate, a country has to sometimes sacrifice its internal problems and growth objectives. 

Fixed Exchange Rate has been discontinued because of many demerits of the system by all leading economies, including India.

A medium of exchange for goods and services is called currency, which is different from one country to another country. However, a country&#x2019s currency cannot be used in another country. For this purpose, the currency of one country is converted into the currency of another country, and the rate at which one currency is exchanged for another is called the Foreign Exchange Rate. Foreign exchange rates can be classified into various types. One of them is the Fixed Exchange Rate System. Fixed Exchange Rate System is determined by the government.