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Fixed exchange rate v flexible exchange rate

By Louise Chan · September 23 2019
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Exchange rates

Fixed exchange rate v flexible exchange rate

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By Louise Chan · September 23 2019
Reading:
egg
egg
egg
Exchange rates

There are two types of exchange rate regimes that operate around the globe: fixed exchange rate regime and flexible or floating rate regime. Rate movements depend on the system a country implements.

Fixed rate regimes refer to a system wherein one country’s currency is pegged at a fixed rate to a major currency, such as the United States dollars, or to something valuable, like gold or silver.

On the other hand, floating rate regimes refer to a system that allows the foreign exchange market to determine a currency’s value according to supply and demand.

Pros and cons of fixed and floating exchange rate

Both fixed and floating exchange rate systems have features that make it attractive for countries to implement, but both systems also have drawbacks that may affect the value of their currencies.

Consider the advantages and disadvantages discussed in the table below.

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  Fixed exchange rate Floating exchange rate
Stability

The fixed exchange rate regime seems more advantageous and stable because the value of a currency remains the same despite changes in economic conditions. 


However, if an economy becomes unable to maintain its peg, the implementation of fixed rate regimes may result in a financial crisis. This could bring about an abrupt devaluation of the currency of affected economies. One example of this is the 1997 Asian financial crisis, which saw a sharp decline in the value of several Asian currencies (up to 38 per cent).

The value of currencies in a floating exchange rate regime is influenced by market forces, enabling rates to self-correct when changes in supply and demand occur.


Under this regime, governments allow the price of their currency to move according to economic conditions.

Revaluation/

devaluation

The value of a currency tends to be fixed until the government implements a change to its value.


Governments may also request a central governing body, such as the International Monetary Fund to revalue its currency.

Governments rarely have to take steps to improve the value of its currency.


The value of currencies “self-corrects” because its price depends on various economic conditions, government stability and the foreign exchange market.

Effect on inflation

Fixed currencies help create a stable environment that attracts foreign investment and creates demand.


With increased demand for its currency, governments would be able to keep inflation at bay for as long as the economy is able to maintain the peg.

Exchange rates can have a direct impact on inflation because when a currency’s value decreases, the prices of imports increase, and this weakens the local currency’s purchasing power.


The inflationary movement will continue until a market correction occurs.

Impact on international trade

A fixed currency value would enable investors to know the value of their investment at any given time. With fewer price fluctuations, investors may feel more at ease.

A flexible currency rate would see the value of investments fluctuate in response to economic and political circumstances. These fluctuations may cause investors to feel nervous or pull out investments based on speculation.

At present, there are no purely fixed or purely floating exchange rate regimes because most countries operate somewhere in between.

There are seemingly fixed exchange rate regimes that implement a crawling peg in which they periodically reassess the value of the peg and adjust the rate accordingly.

Some also implement a managed floating exchange rate wherein the currency is free to move according to market forces but only within government-set limits. That is, the country’s government or central bank implements a floor and ceiling rate for its currency so that it could intervene when the price seems too risky.

 

Fixed exchange rate v flexible exchange rate
Exchange rates
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About the author

Louise is a content producer for Momentum Media’s nestegg who likes keeping up-to-date with all the ways people can work towards financial stability in 2019. She also enjoys turning complex information into easy-to-digest, practical tips to help those who want to achieve financial independence.

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About the author

Louise is a content producer for Momentum Media’s nestegg who likes keeping up-to-date with all the ways people can work towards financial stability in 2019. She also enjoys turning complex information into easy-to-digest, practical tips to help those who want to achieve financial independence.

Join The Nest Egg community

We Translate Complicated Financial Jargon Into Easy-To-Understand Information For Australians

Your email address will be shared with nestegg and subject to our Privacy Policy

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