Difference Between Fixed and Floating Exchange Rate

An Exchange Rate regime is an important component for economy. It is the exchange rate that enables monetary equivalence of currencies, facilitate trade, affects economic activity, inflation, deflation, and provides a way to manage foreign exchange market.

There are many types of exchange rates that exist all over the world across different countries, each with their own pros and cons. The amount of economic currency stability or risk can change drastically throughout different exchange rate regimes. Today, we will look at two of the more well-known and popular exchange rate regimes that countries use- Fixed and Floating Exchange Rate.

Fixed Exchange Rate

Fixed Exchange Rate is a type of Exchange rate regime and is also referred to as Pegged Exchange Rate. As the name suggests, the value of a currency is fixed or pegged by a central bank of the country or a similar institution, by fixing it against another measure of value. This measure of value can be a currency from another country, a currency basket, or gold.

The aim of Fixed Exchange Rate is to stabilize the country's currency, which is usually done by fixing its value against a more stable, more internationally prevalent currency. This means that the market conditions have no effect on the value of the currency with respect to its peg.

Advantages of a Fixed Exchange Rate

1. International Stability: The fixing of currency value against another measure of economic value such as gold, or other more stable currencies, prevents the value of currency from fluctuation.
2. Inflation Control: The currency being fixed and stable in value also means that inflation is easier to control for the government, especially if the peg is also a currency from a low inflation country.
3. Encouraging Investment: When a currency does not fluctuate in value, then it naturally makes MNCs more inclined to invest in the country as the risk of currency changing value and affecting their returns on the investment are reduced.
4. Facilitate Trade: The stabilization of currency reduces overall risk and makes transactions more predictable. This can lead to increased trade volume in the country.
5. Avoid Devaluation: When a currency is fixed by being pegged to a strong currency, then the likelihood of devaluation of this currency is drastically lowered.

Disadvantages of a Fixed Exchange Rate

1. No Auto-Balancing: In a floating exchange rate, a trade deficit might occur, which will increase the price of the foreign currency against the domestic one. This leads to increased prices for the foreign products and services which, in turn pushes the trade deficit down. With a fixed exchange rate, however, this will not happen, the trade deficit may persist.
2. Dependence on Foreign Exchange Reserves: It is possible for the monetary authority like the central bank to run out of their foreign exchange reserves. This can happen when the demand for the foreign reserves exceeds the supply.
3. Less Flexibility: A fixed exchange rate restricts what the central bank or monetary institutions can or cannot change about the monetary policy. Central banks need to increase their interest rates in order to keep their currency stable.
4. Discouraging Foreign Loans: Due to the nature of fixed exchange rates having an increased interest rate, it makes firms less likely to borrow money from the country for export of goods.
5. Forced Devaluation: When a currency crisis occurs in a fixed exchange rate regime, then the central bank is forced to devalue the currency. Firms and agents may try to reduce their net holdings of this currency then, which increases likelihood of forced devaluation, which in turn affects the exchange rate even more.

Floating Exchange Rate

Floating Exchange Rate is also referred to as Fluctuation Exchange Rate or Flexible Exchange Rate. In this type of exchange rate regime, when changes occur in the foreign exchange market, then the value of the currency is also changed. It fluctuates along with the market conditions, and adjusts its value accordingly.

The value of a currency is determined via other currency, a currency basket or measure of material goods. Floating exchange rate is the most widely accepted exchange rate regime in the world. Major currencies such as USD, EURO, INR, etc. are all flexible currencies. It should be noted that being flexible currencies doesn't stop central banks from trying to manipulate their value.

Advantages of a Floating Exchange Rate

1. Automatic Balancing: Whenever a trade deficit occurs, the currency starts to devalue, this in turn would make exports cheaper and also increases demand while also making imports more expensive. This automatically restores the balance. Any imbalance that occurs gets re-balanced through the change occurring in exchange rate.
2. Freeing Internal Policy: Whenever there is a deficit in the balance of payments, a floating exchange rate allows its rectification without having to implement a deflationary policy, simply by changing the external price of that currency.
3. No Currency Crisis: In a fixed exchange rate regime, a country may face currency crisis due to running out of a currency, forcing the central bank to devalue the currency. However, in a floating exchange rate regime, any such crisis is averted as the value of currency fluctuates on its own according to the conditions.
4. Flexibility: Because a currency is allowed to fluctuate in a floating exchange rate regime, it makes responding to changes in world trade or foreign exchange markets much easier and more flexible for the monetary authorities.
5. Inflation Control: If a country is under fixed exchange rate, then the inflation may occur due to importing through higher import prices. In a floating exchange rate however, this does not happen and therefore, keeps inflation more controlled.
6. Lack of Need to Maintain Reserves: A fixed exchange rate system has to maintain reserves for exchange, otherwise it can fall down in a currency crisis and the currency would have to be devalued. There is no such need for reserves in a floating exchange rate, and can be put to use elsewhere for economic growth of the country.

Disadvantages of a Floating Exchange Rate

1. Uncertainty in Trade: Because of the nature of a floating currency, its value may fluctuate on a daily basis. This creates uncertainty in the trade as foreign firms and sellers cannot be sure of the exact value of total currency, they will receive for selling of their goods.
2. Discouraging Investment: Just as traders and MNCs are more inclined to invest in a fixed exchanged rate currency due to reduced risk of return being affected, on the flip side, a floating currency discourages investment as investors have to bear a higher risk of their returns being affected due to fluctuation in value.
3. Volatility: Due to regular fluctuations, predictability is lost. Furthermore, short-term fluctuations and volatility can be high, which cannot be predicted consistently with macroeconomics.
4. Negative Effect on Economy: If a country with floating exchange rate regime is already facing unemployment, inflation, deficit in trade or balance of payments, then the floating nature of the currency may devalue further and worsen the problems even more.

Differences Table

Conclusion

In conclusion, fixed exchange rates offer stability but come with limitations as maintaining a fixed exchange rate requires significant reserves of foreign currency to defend the peg, and it can limit a country's ability to respond to economic shocks. On the other hand, floating exchange rates provide better flexibility for trade but at the cost of more volatility and instability. While most major economies now use floating rates, some developing nations still rely on fixed-rate systems.