Difference Between Fixed and Flexible Exchange Rates

Edited by Diffzy | Updated on: June 06, 2023

       

Difference Between Fixed and Flexible Exchange Rates

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Introduction

If you're in need of exchanging one currency for another, you can turn to a currency exchange business. These companies possess a valid permit to facilitate such transactions for their customers. You'll typically find these transactions taking place face-to-face at teller counters, which are readily available in various shapes and sizes. Whether it's a quaint, one-spot operation, a sprawling chain with franchises in different cities and airports or an esteemed institution affiliated with the country's government or the world at large, there's no shortage of options.

Through physical and online means, currency exchange permits the exchange of one nation's cash for another through buying and selling. To comprehend the process, let's examine a few examples. In order to acquire US Dollars with Indian Rupees, you must present Indian Rupees (Cash, Cheque, or Credit Card) to the currency exchange provider. The exchange rate dictates the quantity you can purchase. You can determine the value of your money in foreign currency by looking at the exchange rate, which is determined by the market.

Difference Between Fixed and Flexible Exchange Rates in Tabular Form

BASIS OF COMPARISONFIXED EXCHANGE RATESFLEXIBLE EXCHANGE RATES
MeaningA fixed exchange rate is one in which the value of one currency is set against the value of a different currency or against another measure of value, such as the value of a precious commodity.A flexible exchange rate is one in which the value of the currency is determined by supply and demand.
Determined byThe government or the central bank.Forces of Demand and Supply.
How it affects CurrencyA fixed exchange rate devalues and evaluates a currency.A flexible exchange rate allows a currency's value to fall and appreciate.
HedgingIf the country has a fixed exchange rate, there is no need for hedging.Hedging is used to decrease currency risks in a flexible exchange rate environment.
SpeculationWhen there is a rumor of a shift in government policy, this occurs.Extremely common.
Mechanism for self-adjustmentIt works by varying the supply of money, the domestic interest rate, and the price.Changes in the exchange rate are used to remove external instability.

What Is Fixed Exchange Rate?

The aim of a fixed exchange rate system is to maintain a particular range for a currency's value by setting it against another currency or a benchmark like gold. An alternative term for this type of system is a 'pegged exchange rate.'

With the rise of globalization, countries are engaging in more business deals with each other, involving transactions and the delivery of goods or services that occur at different intervals. However, if currency rates experience major fluctuations during this period, it can negatively impact the organization. Thus, it's helpful to maintain a stable exchange rate to enhance cost and revenue forecasting.

To stay competitive in the global market and safeguard against unstable market fluctuations, numerous nations opt to peg their currency. Lowered currency values can benefit exports by making them more affordable in overseas markets. As a result, the steady fluctuation of floating exchange rates will have no effect on the economy. Currency pegging is a costly procedure in which the country must use foreign currency reserves to acquire local currency when the value of the currency falls below the peg.   Most countries have tied their currencies to the US dollar, which is tethered to gold and serves as the world's reserve currency.

Advantages of Fixed Exchange Rate

  • It stabilizes the currency value in overseas markets, reducing confusion and risk factors by addressing any excessive volatility.
  • It has remained consistent for a long time. As a result, people feel it will not alter very soon, thereby eliminating its speculations.
  • Any unexpected shift in the currency rate may discourage a lot of business and market operations in tiny countries facing a BOP (balance of payment) problem.
  • It aids in avoiding a sharp depreciation of the currency, which is critical.
  • It encourages foreigners to increase their investments in a country by taking advantage of a currency that is stable.
  • When a fixed exchange rate is properly controlled, it prevents governments from enacting unfavorable macroeconomic policies.
  • It contributes to the regulation of products and service prices. It guarantees that the rate of inflation is kept to a minimum. A good exchange rate is one that is anti-inflationary.

Disadvantages of Fixed Exchange Rate

  • As the currency cannot gain or lose value in response to market forces under a fixed exchange system, the automatic correction of imbalances in the nation's balance of payments will not occur.
  • The application of fiscal and monetary policy will be difficult.
  • The requirement for adequate holding and exchange reserves is an essential condition for maintaining it. As a result, tiny and emerging countries face difficulties.
  • Every country has internal issues to address. However, numerous growth-related objectives and internal difficulties are frequently sacrificed in order to preserve and control the fixed exchange system.

What Is Flexible Exchange Rate?

A flexible exchange rate, sometimes known as a 'fluctuating exchange rate,' is a type of exchange rate system in which the value of a currency is permitted to vary in response to the foreign exchange market mechanism, i.e., demand and supply for the relevant currency. Following the fall of the Bretton Woods system (a monetary management system intended to maintain financial relations within the United States, Canada, Western Europe, Australia, and Japan) in 1971, the currencies of the majority of the world's major economies were permitted to float freely.

Countries can keep their own economic policies by using a flexible exchange rate because their currency is unaffected by changes in another currency or commodity. Countries that adopt a flexible exchange rate system include Georgia, Papua New Guinea, and Argentina. Flexible currency rates provide significant transaction and translation risks. Many organizations employ hedging tactics such as forward-looking agreements, contracts for futures, options, and swaps to reduce such currency risks.

Functions of Flexible Exchange Rates

A flexible exchange rate operates in a marketplace where speculative activity, as well as demand and supply dynamics, determine the price. Because of flexible exchange rate arrangements, variations in long-term currency prices reflect the comparative economic value and interest rate differentials across countries. Changes in the short-term flexible exchange rate reflect disasters, hypotheses, and the currency's daily supply and demand.

Market attitude regarding a country's economy influences how strong or weak the flexible currency is seen to be. For example, if the market perceives a country's government to be unstable, the currency is predicted to decline. Although the government does not totally decide on the flexible exchange rate, it can interfere when the exchange rate is too low or too high in order to maintain currency at a favorable price.

Benefits of Flexible Exchange Rate

1. Balance of payments (BOP) stability

A balance of payments is a time-series account of transactions among entities in one country and entities in the rest of the globe. In theory, any discrepancy in that statement causes the exchange rate to shift.

For example, if the gap is a deficit, the currency will decline. The country's exports would grow cheaper, increasing demand and eventually achieving BOP equilibrium.

2. There are no restrictions on foreign exchange.

Unlike currencies with fixed exchange rates, flexible exchange rate currencies can be exchanged freely. As a result, governments and banks are not required to use a continuous management method.

3. Market efficiency improves

The macroeconomic characteristics of a country influence the flexible exchange rate in international markets, impacting portfolio flows between countries. Thus, flexible exchange rates improve market efficiency.

4. Large amounts of foreign currency are not necessary.

Central banks do not have to retain huge quantities of foreign currency reserves to defend a flexible exchange rate. As a result, the reserves can be used to stimulate economic growth by purchasing capital goods.

5. Protected from import inflation

Countries with fixed currency exchange rates face the dilemma of importing hyperinflation through balance-of-payments surpluses or rising import prices. Countries with variable currency rates, on the other hand, do not confront this issue.

Demerits of Flexible Exchange Rate

  • It promotes economic speculation.
  • The economy lacks stability since the currency rate fluctuates based on demand and supply.
  • Coordination of macro policies becomes inconvenient as a result.
  • There is economic uncertainty, which hampers foreign trade.

Impact

The following sections explore the effects on various areas:

Economic Repercussions

Currency changes have an immediate effect on the country's monetary policy. Currency fluctuations can have a negative impact on the market and foreign and domestic trade.

The Effect on the Consumer

Imports become more expensive when the currency is weak. As a result, the expense is solely borne by consumers. A stable currency, on the other hand, permits people to spend more. The finest example is oil pricing in the worldwide market, where the impact of price variations can be readily seen.

The Effect on Business

Currency fluctuations have an impact on all types of businesses. However, the most effective approach is to focus on export or import company providers. Even if the business does not directly sell or buy foreign currency, these swings may go unnoticed.

Limitations of Flexible Exchange Rate

1. Subjected to exchange rate volatility

Flexible exchange rates are very volatile and prone to changes. A currency's value against another currency might fall in a single trading day. Furthermore, macroeconomic fundamentals cannot explain the short-term volatility of a flexible currency rate.

2. Economic growth or recovery is limited.

The inability to control flexible exchange rates can stifle economic growth or recovery. Negative fluctuations in currency exchange rates may cause major problems. For example, if the dollar climbs against the euro, it will become more difficult to export from the United States to the eurozone.

3. Existing problems may deteriorate.

If a country is experiencing economic troubles, such as unemployment or high inflation, flexible exchange rates may exacerbate the situation. For example, devaluation of a country's currency in a country already experiencing high inflation may lead inflation to rise further due to increased demand for goods. Furthermore, high import costs may exacerbate the country's current account deficit.

Key Differences Between Fixed and Flexible Exchange Rates in Points

In terms of the distinction between fixed and flexible exchange rates, the following points are worth noting:

  • A fixed exchange rate is one that the government sets and keeps at the same level. The flexible exchange rate is one that varies in response to changes in market factors.
  • The fixed exchange rate is set by the government or the country's central bank. The flexible exchange rate, on the other hand, is determined by supply and demand forces.
  • A decrease in the face value of the currency is referred to as devaluation in a system with a fixed exchange rate, whereas an increase is referred to as revaluation. In the flexible exchange rate system, however, a reduction in currency price is seen as depreciation and an increase as appreciation.
  • In the variable exchange rate, speculation is prevalent. In the case of fixed exchange rates, speculation occurs when there is a rumor of a change in government policy.
  • The self-adjusting process in fixed exchange rates works by varying the quantity of money, domestic interest rate, and price. In contrast to the flexible exchange rate, which functions to eliminate external instability caused by changes in the currency rate.

Conclusion

However, in the flexible exchange rate system, a decrease in currency price is referred to as depreciation, while an increase is referred to as appreciation. Speculation is common in the changeable exchange rate. When there is a rumour of a change in government policy, speculation occurs in the case of fixed exchange rates.

In fixed exchange rates, the self-adjusting process operates by modifying the amount of money, domestic interest rate, and price. In contrast to the flexible exchange rate, which serves to avoid external instability induced by currency rate changes. It also explains why their currency does not travel as far as it used to in some countries.

While both fixed and variable exchange rate systems have benefits and drawbacks, it is vital to recognize that no system is flawless.


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"Difference Between Fixed and Flexible Exchange Rates." Diffzy.com, 2024. Thu. 29 Feb. 2024. <https://www.diffzy.com/article/difference-between-fixed-and-flexible-exchange-rates>.



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