Question

Why are speculative attacks more likely in a fixed exchange rate system than a flexible exchange rate system? (Need the exchange rate model too to explain). Thank You.

Answer 1

Speculative attacks are more prominent under the fixed exchange rate system. Speculative attacks occur when the exchange rate is not correctly fixed or it is either overvalued or undervalued.

Under the overvalued exchange rate, the speculators would start selling foreign exchange in the market. it will drag down the exchange rate and the government will be forced to give up the fixed exchange regime.

While under the flexible exchange rate system, the exchange rate is determined through the market forces. Thus, the exchange rate reflect true value. these speculators can not create volatility.