Difference between Fixed and Flexible Exchange Rates

Understanding the differences between fixed and flexible exchange rates is essential for grasping the dynamics of currency markets, assessing their impact on economic performance, and navigating the complexities of international financial systems.

What are Fixed Exchange Rates?

Fixed exchange rates refer to a system in which the value of a country’s currency is fixed or pegged to the value of another currency or a basket of currencies. Under a fixed exchange rate regime, the government or central bank actively intervenes in the foreign exchange market to maintain the exchange rate at a predetermined level.

Key Characteristics of Fixed Exchange Rates:

• Government Intervention: In a fixed exchange rate system, the government or central bank plays a proactive role in regulating the value of the domestic currency.
• Pegged Rate: The exchange rate is pegged or fixed at a specific value relative to another currency, such as the US dollar, or a basket of currencies. This fixed rate is announced and maintained by the monetary authorities.
• Stability: Fixed exchange rates provide stability and predictability in international trade and finance. Businesses can plan their transactions with confidence, knowing that exchange rates will remain constant over the short term.

What are Flexible Exchange Rates?

Flexible exchange rates, also known as floating exchange rates, refer to a system in which the value of a country’s currency is determined by market forces of supply and demand in the foreign exchange market. Under a flexible exchange rate regime, the exchange rate fluctuates freely and is not officially pegged to any other currency or basket of currencies. Instead, it is determined by the interaction of buyers and sellers in the foreign exchange market.

Key Characteristics of Flexible Exchange Rates:

• Market Determination: In a flexible exchange rate system, the exchange rate is determined by the forces of supply and demand in the foreign exchange market.
• Price Volatility: Flexible exchange rates are subject to fluctuations and volatility, as exchange rates adjust continuously in response to changing market conditions.
• Automatic Adjustment Mechanism: Flexible exchange rates serve as an automatic adjustment mechanism to external economic shocks.

Difference between Fixed Exchange Rates and Flexible Exchange Rates

Basis	Fixed Exchange Rates	Flexible Exchange Rates
Definition	A system where a currency’s value is determined and preserved at a fixed rate in relation to another currency or a group of currencies.	A system where supply and demand in the market decide a currency’s value, permitting variations in exchange rates.
Rate Determination	Fixed within a certain range and set by the government or central bank.	Daily rate variations are caused by the foreign exchange market’s determination of the value based on the interactions between buyers and sellers.
Government Control	Requires purchases or sales of currencies on the foreign exchange market by the government in order to preserve the fixed exchange rate.	Minimal government involvement since market forces largely decide currency rates.
Stability of the Currency	Reduces uncertainty for foreign commerce and investment by ensuring stability and predictability in currency values.	Permits fluctuations in currency values to reflect shifts in market forces and economic situations.
Monetary Policy	There is limited freedom to implement independent monetary policy as the money supply and interest rates could have to match the fixed exchange rate.	It gives independent monetary policy makers greater freedom to implement their policies by allowing interest rates and the money supply to be changed in response to changes in the domestic economy.
Payments Balance	Maintains the equilibrium of the balance of payments since minimal exchange rate modifications are possible.	May lead to automatic changes in the balance of payments due to fluctuations in exchange rates.
Exchange Rate Stability	Long-term currency rate stability is provided however, difficulties may arise during periods of economic downturn or external shocks.	Significant swings in exchange rates can occur in reaction to changes in investor attitudes, market dynamics, or economic developments.
Examples	The controlled floating system with a fixed exchange rate regime is implemented by nations such as China.	Nations with liberal exchange rates include the United States, Canada, and the European Union.

Conclusion

Comprehending the distinctions between fixed and flexible exchange rates is vital in order to grasp the workings and consequences of global currency markets. While flexible exchange rates give resilience but also create exchange rate volatility, fixed exchange rates offer stability but restrict the flexibility of monetary policy. Every system has pros and cons, and nations are free to select the exchange rate regime that best suits their goals for trade, economic priorities, and policy.

Fixed Exchange Rates and Flexible Exchange Rates – FAQs

Can the same international financial system support both fixed and variable exchange rates?

It is true that different nations may choose to implement various exchange rate schemes and that fixed and flexible exchange rates may coexist at the same time.

Do foreign trade effects vary depending on whether exchange rates are fixed or flexible?

Sure, although flexible exchange rates enable modifications to reflect changes in economic situations, fixed exchange rates offer stability and predictability for international trade.

Can the effects of fixed and flexible exchange rates on the value of currencies differ?

Set exchange rates link a currency’s value to a set standard or another currency, whereas flexible exchange rates allow for market conditions to determine whether a currency appreciates or depreciates.

Are governments able to intervene in fixed and flexible exchange rate systems?

Flexible exchange rates let the market establish the rate with little to no involvement from the government, whereas fixed exchange rates need interventions to maintain the intended level of the exchange rate.

What drawbacks does the fixed exchange rate have?

The possibility of a currency peg failing and the inability to adapt to shifting economic conditions are some of the drawbacks of a fixed exchange rate system. A nation with a fixed exchange rate may not be able to adapt, which might result in economic issues if the value of its currency rises or falls too much. Additionally, a currency peg may fail, which would greatly increase economic volatility.