Flexible exchange rate : It refers to the system of exchange in which the value of currency is allowed to adjust freely or to float as determined by demand for and supply of exchange. Thus, flexible rate is free to and supply of foreign currency.
Hence, R = f (D, S)
i.e, Exchange rate is a function of demand and supply. (where R = Exchange Rate, D= Demand for various currencies in the international market and S = Supply of various currencies in international market)
The exchange rate at which demand for foreign exchange becomes equal to supply Exchange of Rate’. It is also termed as ‘Normal Rate of Exchange’ or ‘Equilibrium Rate of Exchange’
Merits of flexible Exchange System:-
1) Simple System – It is a simple system in its operation where exchange rate is determined at a point where the demand supply forces of exchange rate become equal.
Hence, it does not need any outside intervention.
2) Continuous Adjustments – There is always a possibility of adjustment in flexible exchange rate and hence adverse effects of long-term disequilibrium can be avoided.
3) Improvement in BOP – Adjustments in balance of payments in flexible exchange rate are smoother as compared with the fixed exchange rate adjustments.
4) Optimum use of Resources – Flexible exchange rate ensures optimum use of resources which consequently increase the level of efficiency in the economy.
Demerits of Flexible Exchange Rate :
1) Bad effect of less Elasticity – Less elasticity in exchange rate makes foreign exchange market unstable and consequently BOP situation becomes worse as a result of depreciation in scarce money.
2) Uncertainty – Flexible exchange rate generates uncertainty and frequent changes in exchange rate discourage international trade and capital movements.
3) Instability in International Trade – Instability in international money market generates instability in international trade. Consequently, formulation of long run policies related to import and export becomes difficult.
