Fixed Versus Floating Exchange Rate

An exchange rate is the price at which one country's currency trades for another on the foreign exchange market There are 2 extreme regimes of exchange rates – floating exchange rate and fixed foreign exchange rate.

Floating Exchange Rate

The floating exchange rate is a market-driven price for currency, whereby the exchange rate is determined entirely by the free market forces of demand and supply of currencies with no government intervention whatsoever.

Broadly, the floating exchange rate regime consists of the independent floating system and the managed floating system. The former is where exchange rate is strictly determined by the free movement of demand and supply. For managed floating system, exchange rate is also determined by free movement of demand and supply but the monetary authorities intervene at certain times to "manage" the exchange rate to prevent high volatilities.

Pros & Cons of Floating Exchange Rate

The floating exchange rate boasts various merits. Firstly, there is automatic correction in the floating exchange rate as the country simply lets it move freely to the equilibrium of demand and supply. Secondly, there is insulation from external economic events as the country's currency is not tied to a possibly high world inflation rate as is under a fixed exchange rate. The free movement of demand and supply helps to insulate the domestic economy from world economic fluctuations. Thirdly, governments are free to choose their domestic policy as a floating exchange rate would allow for automatic correction of any balance of payment disequilibrium that might arise from the implementation of domestic policy.

Nonetheless, there are also specific concerns about the exchange rate being unstable and uncertain under the floating exchange rate regime. Also, speculation tends to be higher in the floating exchange rate regime, hence leading to more uncertainty especially for traders and investors.

Fixed Exchange Rate

For a fixed exchange rate, the government is unwilling to let the country's currency float freely, and they state a level at which the exchange rate will stay. The government takes whatever measures that are necessary to maintain the rate and prevent it from fluctuating. There are two methods which exchange rate could be applied to the price of currencies, a fixed exchange rate and a pegged exchange rate.

Under the fixed exchange rate system, a decrease in the exchange rate which is infrequent are called revaluations. While an increase in the exchange rate are called devaluations. A devaluation in a fixed exchange rate will cause the current account balance to rise, making a country's export less expensive for foreigners and also discourage import by making import products more expensive for domestic consumers,. This will leads to an increase in trade surplus or a decrease in trade deficit. The opposite happens in a revaluation

Pros & Cons of Fixed Exchange Rate

Despite its rigidity, the fixed exchange rate regime is still used for several reasons. First, there is certainty in fixed exchange rate. With it, international trade and investment becomes less risky. Second, there is little or no speculation on a fixed exchange rate.

However, a fixed exchange rate contradicts the objective of having free markets and it is not able to adjust to shocks swiftly like the floating exchange rate.