Fixed vs Floating Exchange Rates (Arguments For and Against) Flashcards
(14 cards)
What is a fixed exchange rate?
A system where the value of a currency is pegged or fixed to another currency (e.g. $) or a basket of currencies, and maintained by central bank intervention (e.g. using reserves, interest rates).
What is a floating exchange rate?
A system where the exchange rate is determined purely by market forces — demand and supply of currencies — without direct government or central bank control.
Advantages of Floating Exchange Rates
No need for currency reserves
→ Central banks don’t have to hold large FX reserves for interventions.
Freedom in domestic monetary policy
→ Can use interest rates freely to target inflation or unemployment.
Automatic adjustment of trade imbalances
→ If a country runs a trade deficit, its currency depreciates (WIDEC), helping to restore balance.
Reduced risk of persistent speculation
→ Market moves toward equilibrium reflecting true economic fundamentals.
Disadvantages of Floating Rates
Volatility and uncertainty
→ Exchange rates can fluctuate significantly → discourages investment and trade.
May overshoot or under-correct
→ Could worsen trade imbalances or inflation in the short run.
Import cost inflation
→ Depreciation = expensive imports = cost-push inflation risk.
Advantages of Fixed Exchange Rates
Stability and certainty for trade and investment
→ Helps businesses plan, price contracts, and reduces FX risk.
Disciplines inflation
→ Governments must keep inflation low to maintain fixed parity (credibility anchor).
Avoids competitive devaluation (“beggar-thy-neighbour”)
→ Prevents countries from artificially devaluing to boost exports.
Disadvantages of Fixed Rates
Requires large currency reserves
→ To defend the peg during pressure, central banks must buy/sell currency.
Loss of monetary policy independence
→ Can’t use interest rates freely; they must defend the exchange rate instead.
Can lead to speculative attacks
→ If markets think a peg is unsustainable (like in ERM crisis 1992).
How do fixed exchange rates reduce uncertainty?
They provide exchange rate stability, which gives confidence to firms engaged in international trade or investment, reducing risk.
How do fixed exchange rates lower the cost of trade?
Businesses don’t need to hedge against currency risk, so transaction costs (e.g. forward contracts) are lower, making international trade cheaper and more predictable.
How do fixed exchange rates discipline domestic producers?
Since they can’t rely on a weaker currency to stay competitive, they’re forced to become more efficient and innovative through investment and R&D.
Can fixed exchange rates be adjusted if needed?
Some flexibility is possible. Governments can devalue or revalue their currency — but these changes are rare and politically sensitive.
What’s a key drawback of defending a fixed exchange rate?
It often requires raising interest rates, which can lead to lower growth and higher unemployment — harming domestic demand.
Why are large currency reserves needed in a fixed system?
The central bank must buy/sell currency to defend the rate. This means holding huge reserves of foreign currency, which is costly and not always sustainable.
What is the risk of speculative attacks?
If markets believe the fixed rate is too high or too low, they may bet against it, forcing governments to use reserves or raise rates — possibly leading to a crisis (e.g. UK’s ERM crisis, 1992).
Why might fixed rates not reflect true economic value?
The fixed rate could be misaligned — either overvalued or undervalued — causing trade imbalances, loss of competitiveness, or inflationary pressures.
