Economics Exchange Rate Systems Questions Medium
Fixed exchange rate system refers to a monetary system in which the value of a country's currency is fixed or pegged to the value of another currency, a basket of currencies, or a commodity such as gold. Under a fixed exchange rate system, the central bank of a country intervenes in the foreign exchange market to maintain the exchange rate at a specific level. This is typically done by buying or selling foreign currencies to stabilize the value of the domestic currency.
On the other hand, a floating exchange rate system, also known as a flexible exchange rate system, allows the value of a country's currency to be determined by market forces of supply and demand. In this system, the exchange rate fluctuates freely based on various factors such as interest rates, inflation, economic performance, and market expectations. The central bank may still intervene in the foreign exchange market to smooth out excessive volatility or to manage the exchange rate within a certain range, but it does not have a fixed target exchange rate.
The main difference between fixed and floating exchange rate systems lies in the degree of flexibility and control that the central bank has over the exchange rate. In a fixed exchange rate system, the central bank has a greater control over the exchange rate as it actively intervenes to maintain the fixed value. This can provide stability and predictability for international trade and investment but may limit the ability to independently pursue monetary policy objectives.
In contrast, a floating exchange rate system allows the exchange rate to adjust freely, which can reflect changes in economic fundamentals and market conditions. This flexibility can help absorb external shocks and promote economic stability. However, it may also introduce uncertainty and volatility in international trade and investment, as the exchange rate can fluctuate significantly.
Overall, the choice between fixed and floating exchange rate systems depends on a country's economic goals, level of economic integration, and the ability to manage exchange rate fluctuations. Both systems have their advantages and disadvantages, and countries may adopt different exchange rate regimes based on their specific circumstances and policy objectives.