Question

Explain the differences between a pegged or fixed exchange rate system and a floating exchange rate system. Provide several pros and cons of each. Provide examples of countries that use each strategy. [This is a Short Answer prompt.]

Answer 1

A fixed exchange rate denotes a nominal exchange rate firmly set by the monetary authority in respect of a foreign currency or a foreign currency basket. By contrast, in foreign exchange markets, a floating exchange rate is determined, depending on demand and supply, and is generally constantly fluctuating. A fixed exchange rate regime reduces transaction costs resulting from uncertainty in exchange rates, which could discourage international trade and investment, and provides a credible anchor for low-inflation monetary policy.

In this system, on the other hand , independent monetary policy is lost, as the central bank must continue to intervene in the foreign exchange market in order to preserve the exchange rate at the officially set level. Autonomous monetary policy thus reflects a significant benefit of a floating exchange rate. If the domestic economy falls into recession, it is autonomous monetary policy that enables the central bank to improve demand, thus 'smoothing' the business cycle, i.e. reducing the effect of economic shocks on domestic production and employment. Both types of exchange rate regime have their advantages and disadvantages, and different countries that choose the right regime depending on their specific characteristics.

The pegged system of exchange rates incorporates aspects of floating and fixed exchange rates. Smaller economies, especially vulnerable to currency fluctuations, may "peg" their currency to a single major currency or a currency basket. These currencies are selected based on which country the smaller economy experiences a great deal of trade activity with or in which currency the debt of the nation is denominated. Once pegged exchange rate agreements are drawn up, the participating countries agree on an initial target exchange rate. There is also a fluctuation range defined to outline appropriate deviations from the target exchange rate. In order to adapt the target rate and fluctuations to the changing economic climate, pegged exchange rate agreements usually have to be reviewed several times over their lifetimes.

At 19, Africa is home to most fixed-currency countries, with 14 using the euro-linked CFA franc and three bound to the South African Rand (ZAR) as part of a Shared Monetary Region. The Middle East is another bastion for fixed exchange rates, with seven countries still sticking to the dollar. Nepal is the only country bound to the Indian rupee, which has increased talk of breaking away from this peg despite the volatile status of INR.