A floating exchange rate is also known as a flexible exchange rate, and changes according to supply and demand. The supply and demand for currency is influenced by a variety of things like international trade, interest rates and foreign investment. Each of these can significantly affect the value of a currency in international markets — for example, if a country is seeing a lot of investment from overseas businesses, the demand for its currency will go up which will, in turn, drive up value and the exchange rate.
This means they use a floating exchange rate but only within a limited range where if the exchange rate gets too low or too high, the government can step in and take action. The big advantage of a fixed rate is stability, plain and simple. This can encourage international trade and help grow economies, which is why many developing African nations go down the fixed route.
The downside of a fixed rate is the sheer effort needed to keep it in check. Open an account Open an account Contact us. Popular topics: Currency 64 Economy 39 News What is the difference between floating and fixed exchange rate regimes? In this piece, we explain the factors distinguishing each model, both of which bear a considerable influence on the currency market.
There are two main types of exchange rate regime: Floating or flexible exchange rate regime Here, there is no specific exchange rate target. Fixed or pegged exchange rate regime The currency rate is set to a particular standard typically another currency or a basket of currencies.
What is a floating or flexible exchange rate regime? Managed floating exchange rate regime According to this system, the central bank regularly intervenes by communicating its desired exchange rate to specialised foreign exchange market operators.
Did you know? Following the Bretton Woods Agreement of , many developed countries adopted a fixed exchange rate regime. The value of their currency was determined according to the price of gold or the US dollar, redeemable in gold at that time. In , the Jamaica Agreement led to the establishment of a widespread floating exchange rate regime governed by supply and demand. Floating Rate vs. Fixed Rate: An Overview. Fixed Rates. Floating Rates.
Special Considerations. Variations on Fixed Rates. Key Takeaways A floating exchange rate is determined by the private market through supply and demand. A fixed, or pegged, rate is a rate the government central bank sets and maintains as the official exchange rate. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear.
Investopedia does not include all offers available in the marketplace. Related Articles. Macroeconomics How the U. Dollar Became the World's Reserve Currency. Partner Links. A clean float, also known as a pure exchange rate, occurs when the value of a currency is determined purely by supply and demand. Learn about the history of the EGP and how to convert the U. Currency Board A currency board is an extreme form of a pegged exchange rate.
Often, it has directions to back all units of domestic currency with foreign currency. Managed Currency A managed currency is one whose value and exchange rate are affected by the intervention of a central bank. Currency Band Definition A currency band represents the floor and ceiling that the price of a given currency can trade between. Investopedia is part of the Dotdash publishing family. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.
For instance, U. Until the domestic price level fell by one-third, U. All else was not equal—exports continued to rise in the s despite the dollar's appreciation. Under a system of fixed exchange rates, U.
Between small countries, a hard peg is also thought to promote more efficient and competitive markets through lower barriers to entry and greater economies of scale. Hard pegs also encourage international capital flows.
First, it allows more investment to take place in areas where saving is relatively scarce and rates of return are high, and investment is key to sustainable growth. This makes both the borrower and the investor better off; the former because more investment, and hence growth, is possible than otherwise would be, the latter because they can now enjoy higher rates of return on their investment for a given amount of risk than if limited to home investment.
For developing countries, these investment gains can be quite large. Because these countries have much lower capital-labor ratios than the developed world, capital investment can yield relatively high returns for some time if a friendly economic environment is constructed. On the other hand, international capital flows can change rapidly in ways that can be destabilizing to developing countries, as will be discussed below.
Weighed against the gains of higher trade and international investment is the loss of the use of fiscal and monetary policy to stabilize the economy. For countries highly integrated with their exchange rate partners, this loss is small. For example, in the euro area, the business cycle of many of the "core" economies e. As long as Belgium does not face separate shocks from France, it does not lose any stabilization capabilities by giving up the ability to set policy independently of France.
By sharing a currency, their fiscal and monetary policy can still be adjusted to respond jointly to shared shocks to their economies, even if these shocks are not shared by the rest of the world—the euro is free to adjust against the rest of the world's currencies.
Troubles only arise if shocks harm one of these countries, but not its partners in the euro. In that case, there cannot be policy adjustment for that country to compensate for the shock. The previous explanation described the economic reasons for establishing currency boards or currency unions. But it is probable that the primary reason for establishing them in developing countries is based more on political reasons.
As has been shown, these monetary arrangements tie the hands of their country's policymakers. For some countries, this is precisely what their policymakers are trying to achieve—a way to prevent the reinstatement of policies from the "bad old days.
Stable growth is impossible when the price mechanism has broken down in this way. The currency board quickly brought the inflation rate in Argentina down to single digits. Whenever a country's inflation rate gets extremely high, it is a reflection of its fiscal policy. Large budget deficits cannot be financed through the sale of debt instruments, so they are instead financed through the printing of money.
Thus, a currency board prevents irresponsible fiscal policy by preventing monetary policy from supporting it. Similarly, Ecuador "dollarized" in —adopting the U. Although extremely high inflation had not yet become a problem, events leading up to dollarization appeared to be pointing in that direction. Investors had become very concerned that inflationary monetary policy would be used to solve its fiscal problems, and dollarization quelled these fears by eliminating that policy option.
Economic analysis sheds little light on the choice between floating exchange rates and a currency board arrangement when the decision is motivated by the desire to find a political arrangement that will prevent the pursuit of bad policies.
Economic analysis can identify bad policy; it cannot explain why it is pursued or how to prevent its recurrence. A currency board is not the only way to tie the hands of policymakers; various rules and targets have been devised to eliminate policy discretion that could be used with a floating exchange rate.
A currency board may be a more final commitment, and hence harder to renege on, than rules and targets, however. Then again, Argentina proved that even currency boards are not permanent. In any case, the political problem of countries monetizing budget deficits seems to be waning. If current trends continue, in the future there may be fewer countries who find it advantageous to accept the harsh medicine of hard pegs to solve their political shortcomings.
Hard pegs are also seen by both proponents and opponents as a means to foster political integration, a topic beyond the scope of this report. This was a primary consideration behind the adoption of the euro. In a traditional fixed exchange rate regime, the government has agreed to buy or sell any amount of currency at a predetermined rate.
That rate may be linked to one foreign currency or unlike a currency board it may be linked to a basket of foreign currencies. In theoretical models, where capital is perfectly mobile and investors consider all countries to be alike, fixed exchange rates would necessarily be functionally equivalent to a currency board. Any attempt to unilaterally influence one's interest rates, through monetary or fiscal policy, would be unsustainable because capital would flow in or out of the country until interest rates had returned to the worldwide level.
In reality, results are not quite so stark. There are transaction costs to investment. Investors demand different risk premiums of different countries, and these risk premiums change over time. There is a strong bias among investors worldwide, particularly in developed countries, to keep more of one's wealth invested domestically than economic theory would suggest. For instance, interest rates in France and Germany should entail similar risks.
Thus, anytime French interest rates exceeded German rates, capital should flow from Germany to France until the rates equalized again.
Yet the commercial interest reference rate, as measured by the OECD, between these two countries has varied by as much as 1. As a result, countries with fixed exchange rates have limited freedom to use monetary and fiscal policy to pursue domestic goals without causing their exchange rate to become unsustainable. By contrast, countries that operate currency boards or participate in currency unions have no monetary or fiscal autonomy.
For this reason, fixed exchange rates can be thought of as "soft pegs," in contrast to the "hard peg" offered by a currency board or union. But compared to a country with a floating exchange rate, the ability of a country with a fixed exchange rate to pursue domestic goals is highly limited.
If a currency became overvalued relative to the country to which it was pegged, then capital would flow out of the country, and the central bank would lose reserves.
When reserves are exhausted and the central bank can no longer meet the demand for foreign currency, devaluation ensues, if it has not already occurred before events reach this point. Interest rates can almost always be increased to a point where capital no longer flows out of the country, but a great contraction in the economy may accompany those rate increases. It is not uncommon to see interest rates reach triple digits at the height of an exchange rate crisis.
Crises ensue because investors do not believe that the government will have the political will to accept the economic hardship required to maintain those interest rates in defense of the currency. As with a hard peg, a fixed exchange rate has the advantage of promoting international trade and investment by eliminating exchange rate risk.
Because the arrangement may be viewed by market participants as less permanent than a currency board, however, it may generate less trade and investment. As with a hard peg, the drawback of a fixed exchange rate compared to floating exchange rates is that the government has less scope to use monetary and fiscal policy to promote domestic economic stability. Thus, it leaves countries unable to defend themselves against idiosyncratic shocks not shared by the country to which it has fixed its currency.
As explained above, this is less of a problem than with a hard peg because imperfect capital mobility does allow for some deviation from the policy of the country or countries to which you are linked. But the shock would need to be temporary in nature because a significant deviation could not last. The scope for the pursuit of domestic goals is greater for countries that fix their exchange rate to a basket of currencies—unlike a hard peg, the country is no longer placed at the mercy of the unique and idiosyncratic policies and shocks of any one foreign country.
One method for creating a currency basket is to compose it of the currencies of the country's primary trading partners, particularly if the partner has a hard currency, with shares set in proportion to each country's proportion of trade. If the correlation of the business cycle with each trading partner is proportional to the share of trade with that country, then the potential for idiosyncratic shocks to harm the economy should be considerably reduced when pegged to a basket of currencies.
On the down side, baskets do not encourage any more bilateral trade and investment than a floating exchange rate because they reintroduce bilateral exchange rate risk with each trading partner.
There is a popular perception that the advantage of a fixed exchange rate is that it allows countries to set their exchange rate below market value in order to boost exports and curb imports. For example, this claim is often leveled against China.
Although it has the benefit of boosting a country's trade balance, it also has costs. By making imports more expensive, it reduces consumers' purchasing power. And by distorting market signals, it funnels resources away from their most efficient use. Finally, an undervalued exchange rate confers no permanent trade advantage because it will eventually cause domestic prices to rise, canceling out the price advantage offered by the exchange rate. In previous decades, it was believed that developing countries with a profligate past could bolster a new commitment to macroeconomic credibility through the use of a fixed exchange rate for two reasons.
First, for countries with inflation rates that were previously very high, the maintenance of fixed exchange rates would act as a signal to market participants that inflation was now under control.
For example, inflation causes the number of dollars that can be bought with one peso to decline just as it causes the number of apples that can be bought with one peso to decline. Thus, a fixed exchange rate can only be maintained if large inflation differentials are eliminated. Second, a fixed exchange rate was thought to anchor inflationary expectations by providing stable import prices.
For a given change in monetary policy, economy theory suggests that inflation will decline faster if people expect lower inflation. After the many crises involving fixed exchange rate regimes in the s and s, this argument has become less persuasive. Unlike a currency board, a fixed exchange rate regime does nothing concrete to tie policymakers' hands and prevent a return to bad macroeconomic policy.
Thus burnt in the past, investors may no longer see a fixed exchange rate as a credible commitment by the government to macroeconomic stability, reducing the benefits of the fixed exchange rate. Furthermore, some currency board proponents claim that this lack of credibility means that investors will "test" the government's commitment to maintaining a soft peg in ways that are costly to the economy.
By contrast, they claim that investors will not test a currency board because they have no doubt of the government's commitment. For this reason, many economists who previously recommended fixed exchange rates on the basis of their political merits have shifted in recent years towards support of a hard peg. This has been dubbed the "bipolar view" of exchange rate regimes: growing international capital mobility has made the world economy behave more similarly to what models have suggested.
As capital flows become more responsive to interest rate differentials, the ability of "soft peg" fixed exchange rate regimes to simultaneously pursue domestic policy goals and maintain the exchange rate has become untenable.
As a result, countries are being pushed toward floating exchange rates the freedom to pursue domestic goals or "hard pegs" policy directed solely toward maintaining the exchange rate. In this view, while "soft pegs" may have been successful in the past, any attempt by a country open to international capital to maintain a soft peg today is likely to end in an exchange rate crisis, as happened to Mexico, the countries of Southeast Asia, Brazil, and Turkey.
Empirically, the trend does appear to be moving in this direction. Although the international trend has been towards greater capital mobility and openness, it should be pointed out that there are still developing countries that are not open to capital flows. The "bipolar view" argument may not hold for these countries: without capital flows reacting to changes in interest rates, these countries may be capable of maintaining a soft peg and an independent monetary policy.
For a fixed exchange rate to work, the relative supply and demand for a country's currency must remain stable over time, or the government must adjust the value at which the exchange rate is fixed whenever supply and demand significantly change.
In practice, the primary problem with fixed exchange rates has been that countries have faced frequent changes in economic conditions that put pressure on the fixed exchange rate to change, but countries have proven unwilling to change the exchange rate promptly. Of course, frequent changes undermine many of the economic and political rationales for using fixed exchange rates.
Some countries have faced economic pressures to raise the value of the exchange rate, others to lower it. An undervalued exchange rate can be maintained indefinitely, as long as the country is willing to accumulate foreign exchange reserves.
But it may lead to political tensions with trading partners, as has been the case recently between China and the United States. When the exchange rate is overvalued, it frequently results in economic crisis, as will be discussed in the next section. The previous discussion summarizes the textbook advantages and disadvantages of different exchange rate regimes.
As such, it abstracts and simplifies from many economic issues that may bear directly on real policymaking. In particular, it neglects the possibility that crisis could be caused or transmitted through international goods or capital markets, and the transmission role exchange rates can play in crisis.
The remainder of the report will be devoted to trying to glean some general lessons from the international crises of the s, which featured rapidly falling exchange rates and asset prices, international capital flight, and financial unrest, to enrich our understanding of how different exchange rate regimes function. The primary lesson seems to be that fixed exchange rate regimes are prone to crisis, while a crisis caused by international capital movements is extremely improbable under floating regimes.
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