compare the advantages and disadvantages of fixed and floating exchange rate systems
Answers
Floating exchange rate is a country’s exchange rate regime where its currency is set by the foreign-exchange market through supply and demand for that particular currency relative to other currencies. Fixed exchange rate is a country’s exchange rate regime under which the government or central bank ties the official exchange rate to another country’s currency (or the price of gold). Each system carries its own pros and cons.
Fixed exchange rate system offers stability, strong incentive for inflation control and some immunity against speculation. Since fixed rate system is ensured against something else stable ie. dollar and gold, investors are more willing to invest since business plans and costs of FDI are reduced. To maintain a fixed rate system, usage of interest rate is crucial however that means exports are vulnerable to the effects of domestic inflation. Therefore, governments are provided strong incentives under control. Lastly, this system allows some protection against speculation since the exchange rate is not determined fully by the market. Since there is the central bank assurance, less speculation goes on.
A fixed exchange rate system refers to the situation when a country values it currency against another currency e.g. the US dollar or a commodity like gold.
A floating exchange rate system is whereby the value of a country's currency against other currencies is determined in an open exchange rate market.
Advantages of a fixed exchange rate system are that, it helps keep the value of a currency stable against other foreign currencies. It brings certainty in foreign trade as it does not keep on changing and helps control inflation and interest rates.
Advantages of a floating exchange rate system are that it is based on demand and supply and does not require government interference. It also helps countries keep from getting affected by problems in other countries.
Disadvantages of fixed exchange rate system is that it requires a country to have large reserves of foreign currency to maintain the value of their currency. In addition it can lead to speculation as the currency it is fixed to changes.
Disadvantages of floating exchange rate system include higher volatility in the value of their currency and uncertainty while in foreign trade.