Question

What determines whether a country will have a fixed or floating exchange rate? Describe the advantages and disadvantages of each. What is the ideal system to you?

Answer 1

There are several factors which help in determining whether the country should adopt fixed or floating exchange rate

Fixed exchange rate refers to the rate fixed by the monetary authority with respect to the foreign currency whereas floating exchange rate refers to the rate that is determined by the foreign exchange market based on various market factors.

Factors determining fixed or floating exchange rate

If the size of the country is small and it's trade is with the large countries, then it's exports and foreign transactions largely depend on its stability. So the country would want to use fixed exchange rate to maintain that stability.

Also when the currency is to be trusted, the fixed exchange rate is used to build confidence of the investors in the country and improve the financial condition.

When a country is large and is not much affected by the changes in its currency or had a strong financial base, floating exchange rate is used.

On the other hand if the currency is unstable, and the monetary authority lacks the foreign reserves to maintain the currency then floating exchange rate is adopted.

Advantages of fixed exchange rate

It maintains stability in the economy

The trust and confidence of the investors is maintained in the currency ,so the investment increases.

It avoids devaluation and keeps inflation low.

Disadvantages of fixed exchange rate

Due to managing the fixed exchange rate, there is little room left for flexibility in the macroeconomic policies.

The foreign exchange reserves deplete if the fluctuations are more and it leads to lesser foreign reserves and causes current account imbalances.

Advantages of floating exchange rate

The country has a larger scope for decision making which is no longer affected by the exchange rate. So the economic efficiency of the nation increases.

Also when in fixed exchange rate , the rate is pegged or fixed against another currency. But here it depends on market factors so it is in a way less affected by the problems of ither countries .

disadvantages of floating exchange rate

Due to instability in the exchange market, there are a lot of fluctuations and volality in the forex market and this affects the trade and other factors with the foreign trading countries.

It may be responsible for other problems and increasing the existing ones. The problem of inflation may get aggravated by the high fluctuations in the floating rate and the investors may withdraw their projects from the market due to these fluctuations.

In my opinion, floating exchange rate is better because it gives more economic independence and is a shock absorber ie prevents the macroeconomic issues of other nations to affect the domestic country adversely.

Als the foreign reserves are not under constant threat to keep the exchange rate fixed. So floating exchange rate is better.

(You can comment for doubts)