4.16 - Fixed & Floating Exchange Rates
Advantages of floating exchange rates
Floating exchange rates allow the value of a currency to be determined by market forces, without direct government intervention. This system provides several benefits for economic management and international trade.
Benefits for monetary policy and economic adjustment
- Freedom in monetary policy - Governments can adjust interest rates to meet internal economic targets, such as stimulating growth through lower rates, which may lead to currency depreciation and higher net exports, or controlling inflation with higher rates, causing appreciation and reduced net exports.
- Self-correcting trade balances - Persistent trade deficits can resolve naturally as excess currency supply in foreign markets causes depreciation, making exports more competitive and imports more expensive, provided the Marshall-Lerner condition holds.
- Gradual market adjustments - Exchange rate changes occur steadily, minimising the risk of sudden economic shocks or crises.
- Smaller foreign exchange reserves - Central banks avoid the need for substantial foreign exchange reserves, as they do not regularly buy or sell to maintain fixed values.
Disadvantages of floating exchange rates
Despite their flexibility, floating exchange rates introduce volatility that can hinder economic stability and planning.
Challenges from volatility and policy freedom
- Increased uncertainty for trade and investment - Frequent and unpredictable rate changes make it difficult for businesses to forecast costs or revenues, potentially reducing international trade and foreign investment.
- Potential for lax economic policies - Governments might pursue overly expansionary measures to boost short-term output, leading to higher inflation without the discipline imposed by fixed rates.
- Vulnerability to speculative attacks - If market sentiment turns negative due to weak economic indicators, speculators can amplify currency falls, causing sharper depreciations than fundamentals would suggest.
Advantages of fixed exchange rates
Fixed exchange rates involve pegging a currency's value to another currency or a basket of currencies, offering stability that supports long-term planning.
Benefits for stability and efficiency
- Enhanced predictability - Stable rates enable firms to better anticipate export earnings and import expenses, encouraging higher levels of trade and cross-border capital movements.
- Promotion of policy restraint - The need to maintain the peg discourages inflationary spending, helping to achieve price stability, which is particularly useful in economies prone to high inflation.
- Encouragement of competitive practices - Businesses must focus on improving productivity and efficiency to stay competitive, as they cannot depend on depreciation to lower export prices.
Disadvantages of fixed exchange rates
Maintaining a fixed exchange rate can restrict a government's ability to respond to economic challenges and impose significant costs.
Limitations on policy and adjustment mechanisms
- Restricted economic tools - Authorities cannot freely use interest rates or exchange rate adjustments to address domestic issues like unemployment or growth slowdowns.
- Constraints on government spending - Large budget deficits may force monetary expansion or rate hikes, both of which conflict with holding the exchange rate steady.
- Abrupt and disruptive changes - When adjustments are needed, such as devaluation or revaluation, they happen suddenly, potentially causing economic instability.
- Difficult correction of trade imbalances - Without automatic depreciation, addressing deficits requires reducing overall demand, which can lead to lower output, economic contraction, and rising joblessness.
- Costly reserve holdings - Central banks must keep large stocks of foreign currencies to defend the peg, tying up resources that earn minimal returns and creating opportunity costs.
Fixed and floating side by side
The four sections above mirror each other: an advantage of one system is usually a disadvantage of the other, so it is worth learning them as pairs.
| Issue | Floating exchange rates | Fixed exchange rates |
|---|---|---|
| Monetary policy | Free to target domestic goals such as growth or inflation | Tied to defending the peg, so unavailable for domestic goals |
| The exchange rate as a policy tool | Available, since the rate itself can adjust | Not available while the peg is held |
| Correcting a trade deficit | Happens automatically through depreciation, provided the Marshall-Lerner condition holds | Requires contractionary policy to reduce demand, which lowers output and raises unemployment |
| Certainty for trade and investment | Lower, because volatile rates make costs and revenues hard to forecast | Higher, because firms can anticipate export earnings and import expenses |
| Policy discipline | Weaker, so expansionary policy is easier to adopt and inflation more likely | Stronger, as holding the peg discourages inflationary spending |
| Speed of adjustment | Gradual and continuous | Sudden, through devaluation or revaluation |
| Foreign currency reserves | Small holdings needed, since the central bank rarely intervenes | Large holdings needed to defend the peg, at a high opportunity cost |
| Pressure on firms to be efficient | Weaker, as depreciation can restore price competitiveness | Stronger, as firms cannot depend on depreciation and must control costs instead |
Destabilising speculation is the one entry with no mirror image, appearing above only as a disadvantage of floating: when the fundamentals point to a weakening currency, heavy selling by speculators can push it down further than those fundamentals justify.
TermDefinition
Floating exchange rateA system where the value of a currency is determined by the market forces of supply and demand, without direct government intervention.
Fixed exchange rateA system where a currency's value is pegged to another currency, a basket of currencies, or a commodity.
Marshall-Lerner conditionThe rule stating that a currency depreciation will only improve a trade balance if the sum of the price elasticities of demand for exports and imports is greater than one.
DevaluationA deliberate downward adjustment of the value of a currency in a fixed exchange rate system.
RevaluationA deliberate upward adjustment of the value of a currency in a fixed exchange rate system.
Foreign exchange reservesForeign currencies held by a central bank, used to intervene in the foreign exchange market to influence the currency's value.