The Differences Between Fixed and Floating Exchange Rates

International Finance and Exchange Rates

International finance as a branch of financial economies concerns itself with monetary interactions which happen between different countries or economies. Currency exchange rates, as well as foreign direct investment, are some of the issues addressed by the international finance. Another issue dealt with the international finance include the foreign exchange risk commonly associated with the management of multinational corporations. International finance is attributed to the exchange participating economies’ prosperity and growth. With the ever-growing globalization, international finance has remained relevant by the magnification of its importance. The exchange rate in finance is known to be the rate at which currencies of different economies exchange. Floating rate and fixed rate constitute the two main types of exchange rates in international finance (Levi, 2016).

The Fixed Exchange Rate

The fixed exchange rate which is also known as the pegged exchange rate is the rate set and maintained by the central bank of a given economy as the official exchange rate for that particular economy. The determination of the currency’s price is done with respect to a major world currency which is commonly the U.S dollar. The central bank of a given economy then has the responsibility of trading its own currency for the currency to which it is pegged in a bid to maintain local exchange rate. Keeping a high level of foreign reserves is a necessity for a given central bank to maintain the set currency rate. These foreign reserves enable a country to either release or absorb extra funds trading in the market. This aspect allows for appropriate fluctuations (inflation and deflation) as well as appropriate money supply in the market. Whenever necessary, a country can adjust the official exchange rate accordingly through its central bank (Draxler, 2017).

The Floating Exchange Rate

On the other hand, the private market is responsible for determining a floating exchange rate mainly through the forces of supply and demand. With floating rate, supply and demand discrepancies in the market correct themselves automatically hence the term “self-correcting.” A low demand for a given currency lowers its value thus making importation an expensive affair, an aspect which stimulates demand for local goods and services. The resultant auto-correction effect in the market involves the creation of more jobs. A floating exchange rate is not constant but rather changing constantly. It is not practical to have a wholly fixed or floating currency of any given economy. Market pressures can compel a fixed regime to change its exchange rate. To prevent inflation and ensure stability, the central bank of a floating regime may intervene when the need arises. However, this aspect is not a common feature attributed to a floating regime (Draxler, 2017).

The Historical Context

A global fixed exchange rate existed in the period between 1870 and 1914 where gold was the common denominator on which currencies were linked. Currencies were fixed at a set exchange rate to gold ounces referred to as the gold standard. The effect of the gold standard was global stability in currencies and trade. The gold standard was later on abandoned at the onset of World War I. However, it was later agreed to fix currencies against the U.S dollar which was in turn fixed against gold. This system collapsed on 1971 from which a floating system was the way forward for many economies of the world. Since then, a majority of the big economies of the world have not contemplated going back to a peg thus completely abandoning the use of gold as a peg (Allsopp, 2014).

Advantages and Disadvantages

Each exchange rate system has its own advantages and disadvantages. A fixed exchange rate regime is mostly preferred due to export and trade. By keeping a country’s exchange rate low, the competitiveness of exports gets supported. When a country with a low cost of production economically associates with stronger currency economies, the real advantage gets manifested as much profit is realized through the exchange rate. Exports from a country with a low exchange rate tend to do well in the international market thus benefiting the domestic companies of that country. For instance, in 2008, China assumed a fixed exchange rate regime after many years of a semi-floated currency (Allsopp, 2014).

Governments, however, have to pay a price to operate a fixed exchange rate system. For a country to maintain the fixed exchange rate, it is necessary to keep a large amount of reserve through the constant trading of the domestic currency by the central bank. For example, the foreign exchange reserves of China grew tremendously in 2010 in a bid to keep the U.S dollar peg. The problem associated with keeping huge currency reserves is that monetary supply grows wider resulting in inflation. China’s 2010 situation resulted in a 5% consumer price inflation. During 1997, the Thai baht greatly depreciated, forcing the Thai government to adopt a floating exchange rate system (Allsopp, 2014).

On the other hand, in a floated exchange rate regime, changes in exchange rates address any change in the balance of payments. For instance, a country’s currency depreciates upon suffering a deficit in the balance of payments, ceteris paribus. The effect to this aspect is the increase of the country’s exports demand by making them cheaper while at the same time discouraging imports by making them expensive. A floating exchange rate also insulates an economy by way of avoiding the importation of highly priced products as is the case with the fixed rate system. Most importantly, with a floating exchange rate system, there is no need of keeping huge foreign currency reserves to develop an economy (Hodgson, 2013).

However, several disadvantages are also associated with the floating exchange rate system. First, there is the aspect of uncertainty into the trade as businesses do not know how much their international sales will yield due to the inconsistencies of currencies from day to day. This uncertainty in trade discourages foreign investment into the involved country. With fixed rate system, there is economy discipline as maintaining the exchange rate is critical while with a floating system, such discipline is usually absent thus ignoring short-run problems such as domestic inflation, an aspect which can result into a crisis situation (Hodgson, 2013).

Conclusion

In international finance, fixed exchange rate and floated exchange rate are the two main attributes of the exchange rate. Global trade, as well as monetary stability, are arguably the product of a peg system which worked during the participation of all the major economies of the world. A floating regime has proven effective in creating equilibrium in the international market, despite its flaws. Considering both the pros and cons of a fixed rate system, it is evident why most economies have a preference for it. An economy can have comparative trading advantages by pegging its currency, an aspect which can also help it protect its economic interests. Nevertheless, whether to adopt a fixed exchange rate system or a floating exchange rate system is for any given economy to decide.

References

Levi, M. (2016). International finance (5th ed., pp. 567-680). London [u.a.]: Routledge.

Allsopp, L. (2014). Common Knowledge and the Value of Defending a Fixed Exchange Rate. SSRN Electronic Journal, 4, 123-137. http://dx.doi.org/10.2139/ssrn.253329

Hodgson, J. (2013). An Analysis of Floating Exchange Rates: The Dollar-Sterling Rate, 1919-1925. Southern Economic Journal, 39(2), 249. http://dx.doi.org/10.2307/1056595

Draxler, A. (2017). Content: International Finance 20/2. International Finance, 20(2), 113-113. http://dx.doi.org/10.1111/infi.12092