An exchange rate system is a mechanism through which the exchange rate of a country is determined. The choice of the exchange rate system has a huge impact on other macroeconomic indicators of the country like inflation, unemployment and on macroeconomic policies like monetary and fiscal policy. We closely look at the fixed and floating exchange rate systems and analyze which is the best in today’s world.
What Is A Fixed Exchange Rate?
A fixed exchange rate is when the central bank of a country pegs its own currency to that of another currency (or a basket of currencies) and maintains the currency rate over a period of years. The central bank fixes a narrow exchange rate range and maintains the currency rate in this range only. Bahrain, United Arab Emirates and Hong Kong are some countries that have been using the fixed exchange rate system.
Countries with this system usually fix their currency rate to one or more major trading partners. Most countries in Africa with a fixed exchange rate peg their currency against the euro whereas most countries in the Middle East peg their currency to the US dollar. Countries prefer pegging their exchange rate against the US dollar and the Euro as these currencies are extremely strong and stable and resultantly less prone to changes compared to other currencies.
Every time there is increased demand or supply, the central bank intervenes in the currency market to maintain the exchange rate within the range defined. In the case of increased demand, the central bank will withhold the supply of the currency to bring demand levels to equilibrium and increase currency supply when demand is low.
Advantages And Disadvantages Of Fixed Exchange Rate System
The foremost advantage of a fixed exchange rate system is stability. Foreign investors feel safer when investing their money into the country as they can speculate the rate of return without being fearful of fluctuations to exchange rates in the future. Moreover, in a fixed exchange rate system, expatriates are more certain of the currency rate they will get when transferring their money. A fixed exchange rate system also leads to lower domestic inflation.
The foremost disadvantage of a fixed exchange rate system is that the central bank needs a lot of foreign reserves to maintain the currency rate. It often happens that banks accumulate large idle reserves of foreign currencies or of their own currency which cannot be utilized. The central bank would also need to constantly monitor the domestic market and international trade and quickly respond to any changes in the market. This can also lead to a currency crisis when the central bank does not have enough foreign exchange reserves and has to devalue or revalue its own currency to maintain the fixed currency rate.
What Is A Floating Exchange Rate?
The floating exchange rate is determined by the forces of the private market of currencies. This means that the forces of demand and supply will determine the exchange rate.
The underlying idea behind the floating exchange rate system is that the currency rate will automatically correct itself to fluctuations in the market. If demand for a currency like the Japanese yen is high, the value of the yen will automatically increase. As the value of the Japanese yen increases, Japanese products will become expensive and imported products will become cheaper which will bring the currency rate back to its previous position. Similarly when the yen decreases in value Japanese products will become cheaper which will lead to an increase in their demand. This self-correcting mechanism also corrects imbalances in the Balance of Payments of a country.
Advantages And Disadvantages Of Free Floating Exchange Rate
Due to automatic adjustment in the free-floating exchange rate, the government or central bank does not have to intervene in the market to maintain the exchange rate. Moreover, when a fixed exchange rate is used by a country, the central bank also has to keep a large reserve of foreign currency to correct any market fluctuations. The resources used to maintain this foreign reserve can be utilized in other areas of the economy like healthcare or education. Under the free-floating exchange rate, this is not required as markets correct themselves based on principles of demand and supply.
However, the free-floating exchange rate system comes with its limitations. Most importantly, the exchange rate is extremely unpredictable and results in uncertainty for foreign investors and expatriates who wish to send money into the country. Also if a country is currently facing economic problems, a floating exchange rate can worsen them. For example, if there is unemployment in a country, depreciation of the currency will lead to further unemployment as imports will become cheaper.
Which Is The Better System?
Although fixed and free-floating exchange rates have their own pros and cons, most economies today use a midway option to these two called the managed floating exchange rate system. In fact, 43% of all countries today are using a managed floating exchange rate, including India and China.
The popularity of the managed floating exchange rate system comes from the fact that it takes advantages of the free-floating exchange rate and eliminates the unpredictability and lack of control that comes with the system.
It mostly happens that when left to market forces, the exchange rate will not automatically correct itself and there always remains the risk of over depreciation or over appreciation of the exchange rate. In a free-floating system, the free market does not always correct itself and more often than not, governments are forced to intervene.
In a managed floating exchange rate system, the market is allowed to work its magic without any government intervention. The government will only intervene when it sees the risk of high depreciation or appreciation of the currency rate.
The popularity of the managed exchange rate system stems from the fact that the other two exchange rate systems have their flaws and there always remains a risk of running an economic or monetary crisis.