Fixed Vs Floating

• Fixed exchange rate


  Exchange rate set and maintained by government intervention
• Floating exchange rate

  Exchange rate determined by market forces of supply and demand
• Advantages of floating exchange rates

  • Reduces need for currency reserves
  • Allows domestic monetary policy to work freely
  • Can help correct current account deficits automatically
  • Useful tool for macroeconomic adjustment
  • Less risk of currency being over/undervalued
• Disadvantages of floating exchange rates

  • No guarantee of stability - can be volatile
  • Volatility reduces incentives for foreign investment and trade
  • Automatic current account deficit correction is mainly theoretical
  • Can worsen inflation issues
• Advantages of fixed exchange rates

  • Lowers exchange rate uncertainty, promoting investment and trade
  • Allows some flexibility through bands and revaluation/devaluation
  • Reduces costs of hedging in futures markets
  • Disciplines domestic producers to improve efficiency
• Disadvantages of fixed exchange rates

  • Using interest rates to maintain can have negative macroeconomic consequences
  • Maintaining large foreign currency reserves may not be viable
  • Risk of speculative attacks if rate is misaligned
• Most economies use floating exchange rates, but allow room for government intervention if needed
• China is an example of a country that intervenes frequently in its floating exchange rate