What are floating and fixed exchange rates and how it affects a countries economy?
A Fixed exchange rate (Pegged exchange rate) -
Between 1870 and 1940, there was a fixed exchange rate between world’s currencies and gold ounces. Value of local currencies was fixed at a set exchange rate to gold ounces. This allowed for
Unrestricted capital mobility
Global stability in currencies and trade
This was known as the Gold Standard. This application was abandoned by world war 1.
Fixed exchange rates are maintained by a central bank or government of a country. A set price will be determined against a major currency in the world or against Gold. (commonly USD). After setting a fixed exchange rate, relevant central bank buys and sells its own currency in the Foreign currency exchange market in return with the currency it pegged to maintain the local exchange rate steady.
Benefits of a fixed exchange rate:-
1. Enables currency value to remain relatively stable
2. Reduce inflation and help to fluctuate in lower levels (help lower inflation)
Problems of a fixed exchange rate:-
1. Country’s currency will lose its monetary independence
2. Will lose control over its currency
A Floating Exchange Rate -
Exchange rate of any given currency pair in any given time.
Floating exchange rate determined by the supply and demand for the relevant currency. A floating exchange rate is constantly changing.
Benefits of a floating exchange rate:-
1. Reduce the level of inflation
2. Automatically stabilizes the economic influence by changing the exchange rate
Problems of a floating exchange rate -
1. Continuation of current economic issues such as inflation. will worsen existing economic issues
2. Has a high volatility in floating exchange rates within a short period of time
At the end of the world war 2, after the Bretton Woods agreement, basic rules and regulations were established for international currency exchange.
International Monetary system were embodied in the International Monetary Fund(IMF). The purpose was to maintain a monetary stability in countries and in the world economy.
Currencies in the world were again fixed/pegged to USD this time and the USD pegged to Gold. 35$ per ounce of gold
This peg was only maintained until 1971 because of the USD could not hold the pegged rate of 35$ per ounce of gold any longer.
In 1985, all attempt to a global peg was totally abandoned.