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A fixed exchange rate policy can have both advantages and disadvantages depending on the economic context of a country, particularly one like the Maldives, which heavily relies on tourism as a primary source of foreign exchange income.

Context of the Maldives:

The Maldives is a small island nation whose economy is largely dependent on tourism, contributing to more than 28% of its GDP and over 60% of its foreign exchange earnings. Recent challenges in tourism, especially due to global economic uncertainties and the aftermath of the COVID-19 pandemic, have significantly impacted the country’s revenue streams. This has led to reduced foreign exchange reserves, making it difficult to maintain a fixed exchange rate.

Fixed Exchange Rate Policy:

A fixed exchange rate system pegs a country’s currency value to that of another major currency, such as the US dollar. The central bank must maintain sufficient foreign reserves to defend this peg and ensure that the exchange rate remains stable.

Pros of Fixed Exchange Rate for the Maldives:

1. Stability and Predictability: A fixed exchange rate provides stability and predictability in foreign transactions, which is crucial for a tourism-driven economy. It helps in maintaining investor confidence and reducing exchange rate risk for businesses and tourists.


2. Control of Inflation: By pegging to a stable foreign currency like the US dollar, the Maldives can control inflation, as a stable exchange rate curbs speculative activities and import cost volatility.


3. Encouragement for Tourism and Investment: A stable exchange rate can make the Maldives an attractive destination for tourists and foreign investors, as it reduces the risk associated with exchange rate fluctuations.



Cons of Fixed Exchange Rate for the Maldives:

1. Pressure on Foreign Reserves: Maintaining a fixed exchange rate requires significant foreign exchange reserves. A slump in tourism reduces the inflow of foreign currency, putting pressure on the central bank to maintain the peg, risking depletion of reserves.


2. Competitive Disadvantage: A fixed exchange rate can make exports less competitive if the pegged currency appreciates relative to other currencies. Since the Maldives imports most of its goods, a strong currency would lead to increased import consumption and reduced competitiveness of domestic products, worsening the trade deficit.


3. Reduced Policy Flexibility: In times of economic downturn, like the recent tourism slump, the Maldives cannot devalue its currency to make tourism more attractive. This inflexibility can lead to prolonged economic stagnation.



Recent Slump in Tourism:

The recent downturn in tourism has significantly reduced foreign currency earnings, impacting the Maldives’ ability to maintain its fixed exchange rate. The decline in tourism has led to a reduction in foreign exchange inflows, which are essential to defend the currency peg. This situation creates a dilemma for the Maldives:

1. Maintaining the Peg: To maintain the fixed exchange rate, the central bank must use its foreign reserves, which are already under pressure. A prolonged tourism slump can deplete these reserves, leading to potential currency crises.


2. Switch to a Flexible Rate: Adopting a more flexible exchange rate could allow the currency to depreciate, making the Maldives a more affordable destination for tourists and potentially boosting the tourism sector. However, this could lead to increased costs for imports, which the Maldives heavily relies on, thereby increasing inflation.

In the current context, maintaining a fixed exchange rate with reduced export (tourism) earnings and high import dependency is challenging. The Maldives may need to reconsider its exchange rate policy or seek alternative measures such as diversifying its economy, seeking international financial assistance, or increasing tourism promotion to attract more foreign exchange inflows. A more flexible exchange rate policy could provide room for economic adjustments, but it must be managed carefully to avoid excessive inflation and loss of investor confidence.