Difference Between Fixed Exchange Rates and Flexible Exchange Rates

Fixed and flexible rates are the two primary categories of exchange rates that are discussed when considering international money transfers. A nation's currency is correlated with gold prices or another currency when there are fixed exchange rates. Conversely, flexible rates are dependent upon the amount of money in circulation.

It is possible that you have heard about the Indian Rupee depreciating against the US dollar. This arises because exchange rates contact everyone, yet not everyone understands how they function.

The cost of exchanging one nation's currency for another is essentially what exchange rates represent. An exchange rate regime refers to the framework that controls these rates. We'll briefly discuss the key differences between fixed and flexible exchange rates in this article.

What Are Fixed Exchange Rates?

When a country's central bank and government keep the value of its currency at a predetermined rate compared to other currencies, this is known as a fixed exchange rate system, often known as a fixed exchange rate. Within certain bounds that are usually set under IMF procedures, this system permits flexibility in the currency rate.

The official exchange rate of the Indian rupee in reference to a reserve currency is decided upon and announced by the Reserve Bank of India (RBI). At that point, private transactions are often paused as the RBI buys and sells foreign currency to keep this rate stable. When the central bank considers it essential, it may alter the exchange rate.

Economies with weaker GDPs and higher rates of inflation often use fixed exchange rates to keep their currencies from shrinking. Stability is desired to guarantee commerce and financial activities are predictable and consistent.

A basket of currencies may also be used as a benchmark for fixed exchange rates to reduce the risk of volatility in a single currency. The British pound, the euro, and the dollar, in different proportions, might all be established as components of a currency. By reducing exposure to fluctuations in the value of a single currency, this diversification helps.

What Are Flexible Exchange Rates?

Systems with flexible exchange rates, also referred to as floating exchange rates, allow a currency's value to fluctuate freely in response to changes in the foreign exchange market. This implies that no action is taken by the government to preserve the value of the currency.

Robust economies often have flexible exchange rates, enabling their currency to freely fluctuate in the market and ultimately discover its real worth. The dynamics of supply and demand in the market influence the exchange rate in this system.

The market determines how much a currency is worth in comparison to other currencies under a floating exchange rate system. A currency's exchange rate rises in response to increased demand, while a currency's value falls in relation to other currencies when there is less demand. Therefore, neither the central bank nor the government have any influence over the currency rate.

Interest rates, foreign investment, and international commerce are a few examples of the variables that affect a currency's supply and demand. The value of a currency on the global market may be greatly impacted by changes in these variables.

Organizations like the International Monetary Fund (IMF) often see adherence to a floating exchange rate system as an indication of financial maturity. On the other hand, other nations use controlled floating, letting their currencies fluctuate within predetermined bounds. The government could step in to maintain the value of the currency if the exchange rate moves too far from this range.

Difference Table

Conclusion

It's critical to understand the difference between fixed and variable exchange rates. Central banks and governments establish fixed rates that relate one currency to another or to a combination of currencies. However, flexible rates are always changing according to supply and demand in the market.

To convert money overseas intelligently, travellers need be familiar with both systems. They need to understand why, in certain cases, their money may not go as far.

Economists argue about these systems' merits and drawbacks constantly. Because they depend on free markets, economists often favor rates that are variable. However, for stability, policymakers often choose fixed rates. The question of the optimal system remains unresolved among economists.