Economics Exchange Rates Questions Long
Fixed exchange rate system and floating exchange rate system are two different approaches to determine the value of a country's currency in relation to other currencies.
Fixed Exchange Rate System:
In a fixed exchange rate system, the value of a country's currency is fixed or pegged to a specific reference currency or a basket of currencies. The central bank or monetary authority of the country intervenes in the foreign exchange market to maintain the exchange rate at the predetermined level. This intervention involves buying or selling foreign currencies to stabilize the exchange rate.
Advantages of a fixed exchange rate system include stability and predictability in international trade and investment. It provides certainty to businesses and reduces exchange rate risk. Additionally, it can help control inflation by limiting the influence of external factors on the domestic economy.
However, there are also disadvantages to a fixed exchange rate system. It requires a significant amount of foreign exchange reserves to intervene in the market and maintain the fixed rate. This can limit the ability of the central bank to pursue independent monetary policy. Additionally, if the fixed exchange rate is not aligned with the economic fundamentals of the country, it can lead to imbalances in the economy, such as trade deficits or surpluses.
Floating Exchange Rate System:
In a floating exchange rate system, the value of a country's currency is determined by market forces of supply and demand in the foreign exchange market. The exchange rate fluctuates freely based on factors such as interest rates, inflation, economic performance, and market expectations. The central bank may still intervene in the market occasionally to stabilize extreme fluctuations or to manage excessive volatility.
The main advantage of a floating exchange rate system is its ability to automatically adjust to changes in economic conditions. It allows the currency to find its equilibrium value, which reflects the underlying economic fundamentals of the country. This flexibility can help absorb external shocks and maintain competitiveness in international trade.
However, a floating exchange rate system also has its drawbacks. Exchange rate volatility can create uncertainty for businesses engaged in international trade and investment. It can also lead to speculative activities in the foreign exchange market, which may cause excessive fluctuations and instability. Additionally, it can make it difficult for countries to control inflation, as the exchange rate may not respond to domestic monetary policy measures.
In conclusion, the main difference between fixed and floating exchange rate systems lies in the mechanism used to determine the value of a country's currency. While a fixed exchange rate system pegs the currency to a specific value, a floating exchange rate system allows the currency to fluctuate freely based on market forces. Each system has its advantages and disadvantages, and the choice between the two depends on the economic priorities and circumstances of the country.