A fixed exchange system is “an exchange rate system where one currency is fixed in value against another. It involves the government working to keep the parity via intervention on the currency markets. These give certainty but can cost vast sums of foreign exchange from national reserves.” Contrarily, a floating exchange rate system “is an exchange rate which accepts that market forces will determine rates based on how they view a country’s trade performance and its economic and political stability. These systems cost less to maintain but can result in vast swings and changes in currency values. This can seriously affect trade performance and confidence.”
Fixed exchange rates
A fixed exchange rate system is one where the value of the exchange rate is fixed to another currency. This means that the government have to intervene in the foreign exchange market to maintain the fixed rate. The equilibrium exchange rate may be either above or below the fixed rate. In Figure 1 below, the equilibrium is above the fixed rate. There is a shortage of the national currency at the fixed rate. This would normally force the equilibrium exchange rate upwards, but the rate is fixed and so cannot be allowed to move. To keep the exchange rate at the fixed rate the government will need to intervene. They will need to sell their own currency from their foreign exchange reserves and buy overseas currencies instead. This has the effect of shifting the supply curve to S2 and as a result, their foreign currency holdings will rise.
Figure 1 Fixed exchange rate – equilibrium above the fixed rate
In Figure 2, the opposite is true – the equilibrium rate is below the fixed rate. This means that there is a surplus of the national currency. The government will need to buy this surplus if they are to prevent the currency from falling – in other words keep it at the fixed rate. When they buy the currency they will be selling from their foreign currency reserves and so these will fall, but the demand for domestic currency will rise.
Floating exchange rates
Where the exchange rate is floating (as are all major currencies in the world), it will be determined by market forces – that is supply and demand. As in any other market, the rate will change constantly to reflect how much of the currency is being traded. However, what determines the supply and demand for the currency? Let’s take the Baht (the Thai currency) as an example and look at the factors that affect supply and demand and therefore the equilibrium exchange rate.
Demand for baht
The people who demand baht are those who have bought goods and services from Thailand and need to pay in baht. To do this they need to sell (supply) their currency and buy (demand) baht in exchange. So, the demand for baht is partly determined by the level of exports – the higher the level of exports, the higher the demand for baht. However, people may also demand baht simply because they want to invest in Thailand or because they are speculating to make a profit, as they believe that exchange rates will change. So the demand for sterling arises from:
- Inflows of funds into Thailand
Supply of baht
The supply of baht comes from people who are selling baht to buy other currencies. We all do that when we travel overseas – we sell baht and buy Euros, $, Yen or whatever. However, we, as tourists, are only a very small part of overall supply of baht. Much of it will come from firms who buy goods and services from overseas (imports), but there may also be outflows of funds and perhaps speculative flows as well. So, the supply of baht arises from:
- Outflows of funds from Thailand
Equilibrium in the market for baht will therefore look as in Figure 1 below.
Figure 1 Equilibrium in the foreign exchange market
If exports were to rise significantly, then this would cause an increase in demand for baht and would shift the demand curve to the right as shown in Figure 2. The exchange rate has appreciated from $0.25 to the baht to $0.35 to the baht. This could also be caused by an increase in Thai interest rates attracting higher demand for baht.
Figure 2 Appreciation in the exchange rate
If imports rose, this would shift the supply curve for baht as more baht would be sold to enable the importers to buy the required foreign exchange. This would shift the supply curve to the right as shown in Figure 3 below. This could also be caused by an outflow of funds due perhaps to a loss of confidence in baht.
Figure 3 A depreciation in the exchange rate
Governments can use exchange rates to affect economic performance. A rising exchange rate, which is often linked to an increase in base interest rates, leads to exports becoming more expensive but imports falling in price. This would reduce part of the inflationary pressure within an economy. A fall in the exchange rate would lead to the reverse and might help domestic businesses export more.
In evaluation, a floating exchange rate is a riskier, more open form of exchange system. It has more potential for growth and loss. On the other side, a fixed exchange rate is a more stable way to manage exchange rates, but there will never be room for growth (or loss). Advantages of the floating exchange system include:
1.Reduced need for currency reserves as reserve banks do not have to intervene in the currency markets to keep a fixed exchange rate.
2.Useful instrument of macroeconomic adjustment
3.Partial automatic correction for a trade deficit
4.Reduced risk of currency speculation on a currency that does not match fundamentals
5.Freedom (autonomy) for domestic monetary policy
The con, as mentioned before, is that because it is so open, there is no safety net, that at any moment the exchange rate can go crashing down. The fixed exchange rate is more stable, but I do not think it is the best system to work with, especially if a country needs to grow and develop.