Define fixed exchange rate? State any two merits and two demerits of fixed exchange rate system.

There are various concepts of exchange rate systems. Its two important types are Fixed Exchange Rate and Flexible Exchange Rate as explained below. (In between these two extreme rates, there are some hybrid systems like Crawling Peg, Managed Floating, etc. which combine merits of both fixed and flexible system of exchange rates. Broadly, when government decides the conversion rate, it is called fixed exchange rate and when market forces determine the rate, it is called flexible (floating) exchange rate.

(a)    Fixed Exchange Rate System. Fixed exchange rate is the rate which is officially fixed by the government/monetary authority on daily or monthly basis. Only a very small adjustment or deviation from this fixed values is possible. In this system foreign central banks stand ready to buy and sell their currencies at a fixed price. In case there is disequilibrium in balance of payment causing excess demand or excess supply of foreign exchange, Central bank of the country has to buy or sell required quantities of foreign exchange to eliminate the excess demand or supply. A typical kind of this system was used under Gold Standard System in which each country committed itself to convert freely its currency into gold at a fixed price. Thus value of each currency was defined in terms of gold, and therefore, exchange rate was fixed. The advantages of this system are as under:
Merits: (i) It ensures stability in exchange rate which encourages foreign trade, (ii) It contributes to the coordination of macro policies of countries in an interdependent world economy, (iii) Fixed exchange rate prevents capital outflow, (iv) It prevents speculation in foreign exchange market. (v) Fixed exchange rates are more conducive to expansion of world trade because it prevents risk and uncertainty in transactions.
Demerits: (i) Fear of devaluation. In a situation of excess demand, Central Bank uses its reserves to maintain fixed exchange rate. But when reserves are exhausted and excess demand still persists, government is compelled to devalue domestic currency. If speculators believe that exchange rate cannot be held for long, they buy foreign exchange in massive amount causing deficit in BOP. This may lead to larger devaluation. This is the main flaw of fixed exchange rate system, (ii) Benefits of free markets are deprived, (iii) There is always possibility of undervaluation or overvaluation.