Question

Explain why a fixed exchange rate is no longer workable?

Answer 1

Solution:

When there is a fixed exchange rate regime then the country need to maintain a large forex reserve in order to maintain that fixed exchange rate. So in order to do so the country need to sell and buy continuously. While doing so it might possible that the country can have very high foreign exchange reserve and this might negatively impact the country. Higher currency reserve might lead to higher inflation as higher money supply will lead to higher prices. China is an example as they followed fixed exchange rate till 2010 and they have now very high foreign exchange reserve and inflation was very high in this period. There are various cases where the country faced severe issues- one such example is the fall of Thai Baht.

Hence now most of the country follows floating exchange rate system.