Which one of the following is the major advantage of flexible exchang…

Which one of the following is the major advantage of flexible exchange rate system?

Answer & explanation

Correct answer: option 3

The correct answer is Option (3) → Movements in the exchange rate automatically take care of the surpluses and deficits in the BoP.

Under a flexible exchange rate system nobody fixes the price of foreign currency: it is set by the market forces of demand for and supply of foreign exchange, like the price of any other good. Because the rate is free to move, it corrects the balance of payments by itself, and this is the system’s major advantage:

A deficit means that the demand for foreign exchange exceeds its supply, so the price of foreign exchange rises and the domestic currency depreciates. Exports become cheaper abroad and imports dearer at home, and the deficit narrows.
A surplus is corrected the same way in the opposite direction.

Why the other options are incorrect

Option (1) The central bank intervenes to moderate the exchange rate movements. — Incorrect. Central bank intervention belongs to the managed floating system, the mixture of flexible and fixed rates; under a purely flexible rate the market alone sets the rate.
Option (2) Government has less flexibility and do not need to maintain large stocks of foreign exchange reserves. — Incorrect. The second half is true, but a flexible rate gives the government more flexibility, not less, because it no longer has to defend a fixed rate.
One word, ‘less’ in place of ‘more’, is enough to turn a true line into a wrong option, so check each word of an option before choosing it.
Option (4) Countries gain independence in conducting their fiscal policies. — Incorrect. The independence gained is in monetary policy: the central bank no longer has to buy and sell foreign exchange to hold the rate, so it can set the money supply and interest rates for the needs of the domestic economy.

NCERT (2025-26): “6.2.3 Merits and Demerits of Flexible and Fixed Exchange Rate Systems … The flexible exchange rate system gives the government more flexibility and they do not need to maintain large stocks of foreign exchange reserves. The major advantage of flexible exchange rates is that movements in the exchange rate automatically take care of the surpluses and deficits in the BoP. Also, countries gain independence in conducting their monetary policies, since they do not have to intervene to maintain exchange rate which are automatically taken care of by the market.…”

Which one of the following is the major advantage of flexible exchange rate system?

Answer & explanation

Correct answer: option 3

The correct answer is Option (3) → Movements in the exchange rate automatically take care of the surpluses and deficits in the BoP.

A deficit means that the demand for foreign exchange exceeds its supply, so the price of foreign exchange rises and the domestic currency depreciates. Exports become cheaper abroad and imports dearer at home, and the deficit narrows.
A surplus is corrected the same way in the opposite direction.

Why the other options are incorrect

Option (1) The central bank intervenes to moderate the exchange rate movements. — Incorrect. Central bank intervention belongs to the managed floating system, the mixture of flexible and fixed rates; under a purely flexible rate the market alone sets the rate.
Option (2) Government has less flexibility and do not need to maintain large stocks of foreign exchange reserves. — Incorrect. The second half is true, but a flexible rate gives the government more flexibility, not less, because it no longer has to defend a fixed rate.
One word, ‘less’ in place of ‘more’, is enough to turn a true line into a wrong option, so check each word of an option before choosing it.
Option (4) Countries gain independence in conducting their fiscal policies. — Incorrect. The independence gained is in monetary policy: the central bank no longer has to buy and sell foreign exchange to hold the rate, so it can set the money supply and interest rates for the needs of the domestic economy.