By Smriti Chand Economics

Difference between Fixed and Floating Exchange Rate on Currency!

Fixed Exchange Rate:

A fixed exchange rate is one, whose value is fixed against the value of another currency (or currencies) and is maintained by the government. The value may be set at a precise value or within a given margin. If market forces are pushing down the value of the currency, the government will step in and seek to increase its price, either by buying the currency or raising the rate of interest.

In Fig. 1, the price of one US dollar is initially two euros. Demand for the dollar rises and, if left to market forces, its price would rise to 2.3 euros. If, however, the government wants to keep the value of the dollar at two euros, it may ask its central bank to sell dollars. If it does so, the supply of dollars traded on the foreign exchange market will increase and price may stay at two euros.

The main advantage of a fixed exchange rate is that it creates certainty. Firms that buy and sell products abroad will know the exact amount they will pay and receive in terms of their own currency, if the exchange rate does not change. A fixed exchange rate can, however, mean that a government has to use up a considerable amount of foreign currency.

If the exchange rate is under downward pressure, it may also have to adopt other macroeconomic policy objectives. If a government cannot maintain an exchange rate at a given parity, it may have to change its value. A change in the value of the currency from one exchange rate to a lower one is referred to as devaluation. A rise in a fixed exchange rate is called a revaluation.

A Floating Exchange Rate:

A floating exchange rate is one which is determined by market forces. If demand for the currency rises or the supply decreases, the value of the currency will rise. Such a rise is referred to as an appreciation. In contrast, depreciation is a fall in the value of a floating exchange rate. It can be caused by a fall in demand for the currency or a rise in its supply. Fig. 2 shows a decrease in demand for pounds sterling, causing the price of the pound to fall.

A floating exchange rate may help to eliminate a growing current account deficit. If demand for import rises whilst demand for exports falls, supply of the currency will rise (as individuals and firms sell it to buy foreign currency) and demand for the currency will fall.

This will lower the value of the currency and hence reduce export prices and raise import prices. Even with a growing current account deficit, however, demand for the currency may rise. Firms and individuals may still buy more of the currency to invest in the country, if they think that economic prospects are good.

A floating exchange rate, nevertheless, does allow a government to concentrate on other objectives. The main disadvantage with a floating exchange rate is that it can fluctuate, making it difficult for firms to plan ahead.