Discuss the differences between a flexible exchange rate and a fixed exchange rate. What measures can the government take to maintain fixed
exchange rates?
Do a little research, then take a shot. What do you think?
Hint: simply understanding how a fixed exchange rate differs from a floating rate should answer most of your questions.
A flexible exchange rate system is one in which the value of a country's currency is determined by market forces, such as supply and demand. In this system, the exchange rate is allowed to freely fluctuate based on various factors, including interest rates, inflation rates, economic growth, and capital flows. The government does not intervene to control or stabilize the exchange rate.
On the other hand, a fixed exchange rate system is one in which the value of a country's currency is tied or pegged to the value of another currency or a basket of currencies. This pegged rate is maintained by the government or central bank through active intervention in the foreign exchange market. The government takes measures to ensure that the exchange rate remains fixed within a specific range or at a specific level.
The main differences between these two systems can be summarized as follows:
1. Exchange rate determination: In a flexible exchange rate system, the exchange rate is determined by market forces of supply and demand. In contrast, in a fixed exchange rate system, the government or central bank actively intervenes to maintain the exchange rate at a desired level.
2. Exchange rate stability: Flexible exchange rates can be subject to significant fluctuations, leading to volatility in currency values. In a fixed exchange rate system, the exchange rate remains stable and predictable as it is determined and maintained by government intervention.
3. Economic policy flexibility: Under a flexible exchange rate regime, the government has more freedom to implement independent monetary and fiscal policies to manage the domestic economy. In a fixed exchange rate system, government policy choices are constrained as they must prioritize maintaining the fixed exchange rate.
To maintain fixed exchange rates, governments can take several measures:
1. Intervention in the foreign exchange market: Governments can buy or sell their currency in the foreign exchange market to influence its value. If the currency is appreciating (gaining value), the government can sell its currency and buy foreign currency to increase the supply of its currency and lower its value. Conversely, if the currency is depreciating (losing value), the government can buy its currency and sell foreign currency to reduce the supply of its currency and increase its value.
2. Capital controls: Governments may impose restrictions on the movement of capital, such as limiting capital outflows or inflows, to control the exchange rate. This helps in preventing abrupt changes in the exchange rate due to speculation or sudden changes in investor sentiment.
3. Monetary policy adjustments: Governments can adjust their monetary policy, such as changing interest rates or reserve requirements, to influence capital flows and thus control the exchange rate.
4. Currency interventions: In extreme cases, governments may intervene in the exchange rate by adjusting the value of their currency peg or changing the exchange rate regime itself.
It's important to note that maintaining fixed exchange rates can be challenging and requires continuous monitoring and intervention. In some cases, governments may face difficulties in sustaining the fixed rate and may eventually be forced to abandon it in favor of a flexible exchange rate system.