What is the Difference Between Fixed and Floating Exchange Rate?

The main difference between fixed and floating exchange rates lies in how they are determined and the volatility they exhibit. Here are the key differences between the two:

• Fixed Exchange Rate:
• A fixed exchange rate is set firmly by the monetary authority with respect to a foreign currency or a basket of foreign currencies.
• The government decides the exchange rate and maintains it by intervening in the foreign exchange market.
• This system reduces transaction costs implied by exchange rate uncertainty, which might discourage international trade and investment.
• Fixed exchange rates work well for growing economies that do not have a stable monetary policy, as they help bring stability to a country's economy and attract foreign investment.
• Examples of countries with fixed exchange rates include those in Africa and the Middle East, which often peg their rate to the U.S. dollar, the euro, the yen, or a basket of currencies.
• Floating Exchange Rate:
• A floating exchange rate is determined in foreign exchange markets depending on demand and supply, and it generally fluctuates constantly.
• The flexible exchange rate system is dependent on the demand and supply of money in the market.
• This system allows for automatic adjustments in the balance of payments, as any deficit or surplus is corrected by changes in the exchange rate.
• Floating exchange rates work better for countries that already have a stable and effective monetary policy, such as the United States and most major currencies in the world.
• In a floating rate system, the currency appreciates and depreciates based on market forces, and there is no need for maintaining foreign reserves.

In practice, there are various exchange rate regimes lying between these two extreme variants, providing a compromise between stability and flexibility.

Comparative Table: Fixed vs Floating Exchange Rate

The main difference between fixed and floating exchange rates lies in how they are determined and adjusted. Here is a table comparing the two systems:

In summary, fixed exchange rates provide more stability and certainty, while floating exchange rates allow for more flexibility and monetary policy independence. The choice between the two systems depends on a country's specific economic and political conditions.