It is sometimes maintained that a case for flexible exchange rate is a case against fixed exchange rate. This is so, but only partially. This is because there are also several cogent arguments against fixed rate.
1. Domestic Stability:
With a fixed exchange rate, adjustment of domestic price level vis-a-vis that of the rest of the world has to be brought about through an inflationary or deflationary domestic policy. This implies sacrificing domestic stability for the sake of exchange rate stability.
2. Curbing Competitive Market Forces:
If we believe in the virtues of a competitive market, we should opt for a flexible and not a fixed rate. This is because a fixed rate regime is the one in which competitive market forces are not allowed to operate freely.
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In particular, a policy of exchange convertibility and free international trade imply that fixed exchange is a baseless policy.
3. Choice of Rate:
There is no objective method of estimating the most appropriate fixed rate of exchange and adopt it. Its estimation would involve a number of factors including those prevailing in international markets and policies adopted by other countries.
Whether or not the rate chosen is optimum can be judged only by first adopting it and then studying its impact on the economy.
4. Transient Nature:
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There is no rate which is optimum for all times to come. The very dynamism of modern economies means that exchange rates should also be adjusted in response to the changing situation.
5. Economic Cost of Controls:
A successful policy of fixed exchange rate necessitates a system of controls which has its own economic costs, including possibility of misallocation of productive resources.
6. Retarding Trade and Capital Flows:
Procedural hurdles restrict and retard international trade and capital flows, which could be ends in themselves for Exchange Control Authorities, based on various priorities before them.