Exchange Rates: Fixed vs Floating (A2 Macroeconomics)

The exchange rate is the price at which one currency is exchanged for another on the foreign exchange (FOREX) market. Two of the main types of exchange rate used by Governments are a free floating exchange rate and fixed exchange rate.

The Free Floating Exchange Rate

A free floating exchange rate is a system whereby the price of one currency expressed in terms of another is determined by the forces of demand and supply.

Advantages:

• A floating exchange rate means that a government can have a larger focus on achieving other macroeconomic objectives. For example, there is no need to set interest rates to achieve an exchange rate target so interest rates can be used to achieve price stability or encourage investment.
• Automatic adjustment should ensure a Balance of Payments equilibrium is achieved. For example, if a country has a balance of payments deficit then the currency should depreciate. This is because a deficit means that imports will be greater than exports. As a result, the supply of the nations currency will exceed its demand on the FOREX market which will cause the value of the currency to depreciate. This will make exports cheaper (and so raise demand) and imports more expensive (reducing demand), eliminating the B of P deficit. 
• It may be easier to adjust to external economic shocks such as a global recession. A global recession would reduce the demand for exports, causing reduced demand for currency on the FOREX markets and lead to a depreciation in the value of the currency, lowering the price of exports and making them more attractive.

Disadvantages:

• A changing value of a currency may result in consumer uncertainty. Exporters may be unsure of how much money they will receive when they sell abroad and importers may not know exactly how much it is going to cost to import a foreign good.
• The freedom to set domestic policy does not guarantee that price stability will be prioritised over other objectives. Automatic adjustment mechanisms may lead to governments pursuing short-term economic growth at the expense of higher inflation.
• The floating exchange rate can be inflationary by allowing import prices to rise as the exchange rate depreciates. This particularly an issue for countries who depend on imports for the provision of certain goods such as exotic foods.

The Fixed Exchange Rate

In a fixed exchange rate system, the government intervenes in the currency market so that the exchange rate stays close to an exchange rate target. 

Advantages:  

• A fixed exchange rate provides certainty for traders, investors and consumers by allowing the price of imports and exports to remain more stable. Some economists argue that this will result in higher levels of trade and investment.
• Fixed exchange rates can impose financial discipline on domestic firms to keep their costs under control in order to remain competitive in international markets. This helps the government maintain low inflation, which in the long run should reduce interest rates and stimulate trade and investment.
• A fixed exchange rate reduces the costs of international trade to firms by removing the need of hedging (limiting the risk that losses are made in changes in the price of currencies by buying currencies in future markets).

Disadvantages: 

• It may be difficult to work out the initial fixing of the rate of exchange. If it is fixed at a rate too high, exports will remain relatively expensive and imports cheap. This will result in a long term loss in international competitiveness by domestic firms and a poor position in the current account of the balance of payments. 
• In order to fix the exchange rate, the government will need to maintain a high level of foreign currency reserves in order to intervene on the FOREX market. This incurs an opportunity cost. In addition, whilst maintaining the exchange at a fixed rate, other macroeconomic policy objectives may be sacrificed. For example, governments may alter interest rates in order to influence the rate of exchange, conflicting with with the objective of maintaining price stability. 
• A fixing of the exchange rate could result in retaliation by other nations. Retaliation may take the form of protectionist measures such as trade barriers against imports from domestic firms. This will increase the price of exports, thus rendering the fixed rate ineffective in increasing trade.