Advantages and disadvantages of fixed and floating exchange rate system pdf

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Advantages and Disadvantages of Freely Floating Exchange Rates

Fixed exchange rate systems were common during the first half of the 20th century. They were strongly favored by governments, since they were mistakenly believed to offer three key advantages. First, they would lower the risk of speculative capital flows that could destabilize the economy. Second, they would introduce greater discipline on domestic policies to avoid inflation. Third, they would remove exchange rate risk and therefore promote international trade.

It was thought that speculation would inevitably create unworkable volatility and destabilize a flexible, or freely floating, exchange rate. This would be a damaging for small economies that relied on a high level of international trade. Exports weaken and imports strengthen. These twin pressures worsen the balance of payment positions as the economy becomes less competitive relative to overseas countries, leading to unemployment.

These forces, it was thought, would pressure governments to implement anti-inflation policies. A fixed exchange rate removes the risk of exchange rate changes. It was thought the absence of this risk was benefit international trade and capital flows. During the decades immediately following World War II, the advantages of fixed exchange rates proved less powerful than earlier presumed.

Moreover, various theoretical developments argued for freely floating, rather than fixed or managed exchange rate systems, and better highlighted the following disadvantages of a fixed exchange rate. A fixed exchange rate does not automatically correct a balance of payments disequilibrium. A fixed system forces a government to correct the disequilibrium by raising interest rates and lowering domestic demand. This restrains domestic economic policies from focusing on unemployment and inflation.

By contrast, a floating exchange rate liberates domestic policies and automatically devalues the currency to correct the external imbalance. A fixed exchange rate requires a government to maintain significant value as foreign exchange reserves. These reserves have an opportunity cost in the form of foregone financial return. Fixed rates do not automatically harmonize different domestic economic policies that differ between countries.

For example, high inflation countries will be uncompetitive versus low inflation countries. This creates speculation of a once-off devaluation, placing pressure on government to devalue. Sebastian Lee has been writing professionally since

Fixed, Floating and Managed Exchange Rates

Crawling peg is an exchange rate regime that allows depreciation or appreciation to happen gradually. It is usually seen as a part of a fixed exchange rate regime. The system is a method to fully use the key attributes of the fixed exchange regimes as well as the flexibility of the floating exchange rate regime. The system is shaped to peg at a certain value but at the same time is designed to "glide" to respond to external market uncertainties. To react to external pressure such as interest rate differentials or changes in foreign-exchange reserves to appreciate or depreciate the exchange rate, the system can have moderately-sized, frequent exchange rate changes to ensure that the economic dislocation is minimized. Some central banks use a formula that triggers a change when certain conditions are met, while others prefer not to use a preset formula and frequently change the exchange rate to discourage speculations. The main advantages of a crawling peg are that it avoids economic instability as a result of infrequent and discrete adjustments fixed exchange rate [1] and it minimizes the rate of uncertainty and volatility since the fluctuation in the exchange rate is kept minimal floating exchange regime.

The freely floating currency system is the predominant system of foreign exchange that is prevalent in the world today. As globalization has progressed, more countries have abandoned their currency pegs and have allowed their currencies to freely float. Some have been forced to do so by market participants whereas others have made their choice in the light of the advantages that this system has to offer. In this article, we will have a look at the advantages and disadvantages that are faced by any country when it adopts a floating exchange rate regime. Market Determined Rates: Freely floating exchange rate means that the market will determine the rate at which one currency can be exchanged for another. The market will set these rates on a real time basis as and when new information flows in. This reduces the need for an elaborate mechanism to ensure that the exchange rates remain within a particular range.

A fixed exchange rate denotes a nominal exchange rate that is set firmly by the monetary authority with respect to a foreign currency or a basket of foreign currencies. By contrast, a floating exchange rate is determined in foreign exchange markets depending on demand and supply, and it generally fluctuates constantly. A fixed exchange rate regime reduces the transaction costs implied by exchange rate uncertainty, which might discourage international trade and investment, and provides a credible anchor for low-inflationary monetary policy. On the other hand, autonomous monetary policy is lost in this regime, since the central bank must keep intervening in the foreign exchange market to maintain the exchange rate at the officially set level. Autonomous monetary policy is thus a big advantage of a floating exchange rate. If the domestic economy slips into recession, it is autonomous monetary policy that enables the central bank to boost demand, thus 'smoothing" the business cycle, i.

Floating Exchange Rates: Advantages and Disadvantages | Currencies. Automatic Stabilisation: Any disequilibrium in the balance of payments would be automatically corrected by a change in the exchange rate. Freeing Internal Policy: Absence of Crisis: Management: Flexibility: Avoiding Inflation: Lower Reserves.

Crawling peg

Fixed exchange rate systems were common during the first half of the 20th century. They were strongly favored by governments, since they were mistakenly believed to offer three key advantages. First, they would lower the risk of speculative capital flows that could destabilize the economy. Second, they would introduce greater discipline on domestic policies to avoid inflation.

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International economics

One of the big issues in international finance is the appropriate choice of a monetary system. Countries can choose between a floating exchange rate system and a variety of fixed exchange rate systems. Which system is better is explored in this chapter. However, rather than suggesting a definitive answer, the chapter highlights the pros and cons of each type of system, arguing in the end that both systems can and have worked in some circumstances and failed in others. This chapter addresses what is perhaps the most important policy issue in international finance: to have fixed or floating exchange rates. The chapter focuses on three main features that affect the choice of system: volatility and risk, inflationary consequences, and monetary autonomy. Volatility and risk refers to the tendency for exchange rates to change and the effect these changes have on the risk faced by traders and investors.

International economics. Table of Contents Topic pack - International economics - introduction Terms and definitions Games and activities International Organisations Section 4. Advantages and disadvantages of exchange rate systems Advantages and disadvantages of fixed exchange rates Advantages of fixed exchange rates Certainty - with a fixed exchange rate, firms will always know the exchange rate and this makes trade and investment less risky. Absence of speculation - with a fixed exchange rate, there will be no speculation if people believe that the rate will stay fixed with no revaluation or devaluation. Constraint on government policy - if the exchange rate is fixed, then the government may be unable to pursue extreme or irresponsible macro-economic policies as these would cause a run on the foreign exchange reserves and this would be unsustainable in the medium-term. Disadvantages of fixed exchange rates The economy may be unable to respond to shocks - a fixed exchange rate means that there may be no mechanism for the government to respond rapidly to balance of payments crises.

Unlike fixed exchange rates, these currencies float freely, that is, unrestrained by government controls or trade limits. In consequence, floating exchange rates are in continuous fluctuation. Changes in factors such as interest rates, inflation, political stability, trade flows, tourism and speculation, just to name a few, maintain free-floating currencies in continuous movement. This volatility is perceived as a positive aspect for currency speculators, who account for the vast majority of FX market trading. For companies carrying out business in foreign currencies, however, it poses translation and transaction risks that might seriously impact their profit margins.

Floating Rate vs. Fixed Rate: What's the Difference?

Exchange Rate Risk for Investors

A fixed exchange rate occurs when a country keeps the value of its currency at a certain level against another currency. Often countries join a semi-fixed exchange rate, where the currency can fluctuate within a small target level. Avoid currency fluctuations. If the value of currencies fluctuates, significantly this can cause problems for firms engaged in trade. Stability encourages investment. The uncertainty of exchange rate fluctuations can reduce the incentive for firms to invest in export capacity. A fixed exchange rate provides greater certainty and encourages firms to invest.

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