Explain clearly the difference between fixed exchange rate and a floating exchange system
A fixed exchange rate system is a monetary system in which a country's currency is pegged to the value of another currency, a composite of multiple currencies, or even a physical asset like gold. The exchange rate between the two currencies is set and does not fluctuate freely based on market forces. Central banks actively intervene in the currency market to maintain the fixed exchange rate by buying or selling their own currency against the pegged currency.
In contrast, a floating exchange rate system, also known as a flexible exchange rate system, is a monetary system in which the value of a country's currency is determined by market forces of supply and demand. It means that the exchange rate of a currency fluctuates freely in response to changes in the international currency market. Central banks usually do not intervene in the currency market to control or fix the exchange rate under a floating exchange rate system.
The main differences between the two systems are as follows:
1. Exchange rate determination: In a fixed exchange rate system, the exchange rate is determined and fixed by the government or central bank, which means it remains constant over a certain period, usually until the government decides to change it. In a floating exchange rate system, the exchange rate is determined by the free market forces of supply and demand, resulting in constant fluctuations.
2. Market intervention: In a fixed exchange rate system, central banks actively intervene in the currency market to maintain the exchange rate within a desired range. They buy or sell their own currency to stabilize the exchange rate. In a floating exchange rate system, central banks rarely intervene, allowing the exchange rate to be determined purely by market forces.
3. Economic stability: A fixed exchange rate system provides stability as it eliminates uncertainty in international trade and investment. It ensures that exchange rates are predictable, making it easier for businesses and individuals to plan and make long-term decisions. However, a fixed exchange rate system may also lead to imbalances in the economy, as the government may need to implement restrictive monetary policies to maintain the fixed exchange rate. A floating exchange rate system allows greater flexibility and adjusts automatically to market conditions, providing a natural mechanism to absorb shocks. However, it also introduces uncertainties and risks for businesses due to currency fluctuations.
4. Economic policy autonomy: In a fixed exchange rate system, a country's monetary policy is influenced by the currency to which it is pegged. The central bank has limited flexibility in adjusting interest rates and money supply as it needs to maintain the exchange rate. In a floating exchange rate system, a country has more autonomy in implementing its own monetary policy to control inflation, promote economic growth, or manage a financial crisis.
Overall, the choice between a fixed exchange rate system and a floating exchange rate system depends on a country's economic and political circumstances, its objectives, and the level of exchange rate stability it desires.
A fixed exchange rate system is a monetary arrangement where the value of a currency is officially set and maintained at a particular level against another currency or a basket of currencies. In this system, the government or the central bank intervenes in the foreign exchange market to control the exchange rate. They buy or sell their own currency to maintain the fixed rate.
On the other hand, a floating exchange rate system is a monetary arrangement where the value of a currency is determined by market forces of supply and demand. In this system, the exchange rate fluctuates freely in response to changes in economic conditions, market expectations, and other factors. The government or central bank does not intervene directly to support or control the exchange rate.
Here are the key differences between fixed and floating exchange rate systems:
1. Control: In a fixed exchange rate system, the government or central bank actively manages the currency's value and intervenes in the market to ensure it remains fixed. In a floating exchange rate system, the market forces determine the currency's value, and the government or central bank does not actively intervene.
2. Stability: Fixed exchange rates provide stability as they eliminate uncertainty in international transactions. Businesses and investors can rely on stable exchange rates for planning and decision making. Floating exchange rates, on the other hand, can be more volatile and subject to fluctuations due to market forces.
3. Monetary Policy Autonomy: In a fixed exchange rate system, the central bank's ability to implement independent monetary policy is limited since it has to maintain the fixed rate. Governments usually need to maintain foreign exchange reserves to intervene in the market, which can affect their ability to pursue domestic economic policies. In a floating exchange rate system, the central bank has more flexibility in implementing monetary policy as it is not tied to a fixed rate.
4. Trade Balance Adjustment: In a fixed exchange rate system, adjustments in the trade balance are typically achieved through changes in domestic economic policies, such as fiscal policies or controls on imports and exports. In a floating exchange rate system, the exchange rate itself adjusts to reflect changes in the trade balance. If a country has a trade deficit, its currency will depreciate, making its exports more competitive and imports more expensive.
Overall, the main difference between fixed and floating exchange rate systems lies in the level of control and intervention by the government or central bank and the flexibility of the exchange rate to adjust to market forces.