Demerits of the Flexible Exchange Rate System

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

1. Uncertainty and Confusion: The flexible exchange rate system causes uncertainty and confusion in trade and investment. It means that, when the exchange rate fluctuates freely, the likelihood of uncertainty increases. For example, an Indian trader dispatches an export invoice to a US buyer without any knowledge about the price at which the foreign currency will be converted into Indian Rupees. This type of uncertainty affects trade. However, it can be reduced by using forward exchange contracts.

2. Inflationary Effect: Under a flexible exchange rate system, the chances of the inflationary effect of exchange depreciation on a country’s domestic price level are more. Besides, due to the inflationary rise in price, the external value of the currency depreciates.

3. Unnecessary Capital Movements: There is unnecessary capital movement due to fluctuating exchange rate system. This system also causes large-scale capital inflow and outflow by encouraging different speculative activities, which disturbs the economy of the country.

4. Hampers Investment: When there is an unregulated flexible exchange rate, it makes the exchange rate erratic and as a result discourages foreign investment. Besides, as the exchange rate under this system is uncertain and has an impact on the profit and loss implications of a foreign investment deal, there are chances that a country experiences decumulation of capital.

5. Adverse Effect on Economic Structure: Flexible exchange rate system has an adverse impact on the economy of a country. The flexible exchange rates causes a change in the price of exported goods and imported goods, which destabilise the country’s economy.

6. Failure of Flexible Exchange Rate System: The experience of countries under the flexible exchange rate system adopted between the two world wars was not good, making this system flop.

A medium of exchange for goods and services is called currency, which is different from one country to another country. However, a country’s 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 Flexible Exchange Rate System. Flexible Exchange Rate System is determined by the forces of demand and supply of different currencies in the foreign exchange market.