Difference between Fixed and Flexible Exchange Rate

Introduction:

Exchange rate systems play a crucial role in a country’s economic stability and international trade. There are two primary types of exchange rate systems: fixed and flexible. Understanding the differences between these systems is essential for commerce students, economists, and financial professionals. Each system has its own set of advantages and disadvantages, depending on the economic goals and conditions of the country.

What is a Fixed Exchange Rate?

A fixed exchange rate system is one in which the value of a country’s currency is pegged or fixed to another major currency, such as the US dollar, or a basket of currencies. The exchange rate is determined and maintained by the government or other monetary authorities, rather than by market forces. The central government ensures that the exchange rate remains stable by intervening in the currency market when necessary.

Key Features of Fixed Exchange Rate:

Determined by Government: The central government sets and maintains the exchange rate.
Stability: Provides stability in international prices, which can help in controlling inflation.
Government Intervention: The central bank must intervene in the foreign exchange market to maintain the fixed rate.
Maintenance of Foreign Reserves: The government needs to maintain large foreign reserves to defend the fixed exchange rate.

What is a Flexible Exchange Rate?

A flexible exchange rate system, also known as a floating exchange rate, is one where the value of the currency is determined by market forces, such as supply and demand. The exchange rate fluctuates freely, and there is minimal government intervention. The currency’s value can appreciate or depreciate based on various economic factors, including trade balances, inflation rates, and interest rates.

Key Features of Flexible Exchange Rate:

Market-Determined: The exchange rate is determined by the forces of demand and supply in the foreign exchange market.
Fluctuations: The currency’s value can fluctuate, leading to potential appreciation or depreciation.
No Need for Government Intervention: The government or central bank does not need to intervene to maintain the exchange rate.
Automatic Correction of BOP: Any deficits or surpluses in the balance of payments are automatically corrected through the exchange rate adjustments.

Key Differences Between Fixed and Flexible Exchange Rates

Aspect	Fixed Exchange Rate	Flexible Exchange Rate
Definition	A system where the exchange rate is determined by the government or monetary authorities.	A system where the exchange rate is determined by market forces, such as demand and supply.
Determining Authority	Set and maintained by the central government.	Determined by the forces of demand and supply in the currency market.
Currency Impact	The currency can be devalued or revalued by the government.	The currency can appreciate or depreciate based on market conditions.
Government Bank Participation	The government or central bank actively participates in maintaining the fixed rate.	No active participation of the government or central bank in maintaining the rate.
Maintaining Foreign Reserves	Necessary to maintain large foreign reserves to defend the fixed rate.	No need to maintain foreign reserves as the market determines the exchange rate.
Impact on BOP	Can cause a deficit in the Balance of Payments (BOP) that may be difficult to correct.	The BOP automatically adjusts any deficit or surplus through changes in the exchange rate.

Conclusion:

Fixed and flexible exchange rate systems each have their own merits and drawbacks. A fixed exchange rate provides stability and predictability but requires significant government intervention and foreign reserves. On the other hand, a flexible exchange rate allows for automatic adjustments based on market conditions but can lead to greater currency volatility. Understanding these differences is crucial for making informed decisions in international trade, finance, and economic policy.