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.

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. In comparison, in foreign exchange markets, a floating exchange rate is set, based on demand and supply, and is typically constantly fluctuating.

A fixed exchange rate system lowers transaction costs arising from volatility in exchange rates, which may deter foreign trade and investment, and offers a reliable basis for low-inflation monetary policy. Under this system, on the other hand, independent monetary policy is lost, as the central bank must continue to intervene under 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 Czech Republic's exchange rate was bound to a basket of currencies until early 1996, then the peg was effectively abolished by a significant expansion of the fluctuation band, and now the Czech economy operates under the so-called controlled floating system , i.e. the exchange rate is floating, but the central bank may resort to interventions if there are any severe fluctuations.

As with a hard peg, the advantage of a fixed exchange rate is that it encourages foreign trade and investment by reducing exchange rate risk. However, given that market participants may perceive the agreement as less stable than a currency board, it could produce less trade and investment.

The downside of a fixed exchange rate as opposed to floating exchange rates, as with a hard peg, is that the government has less flexibility to use monetary and fiscal policy to promote domestic economic stability. So it leaves countries unable to defend themselves against idiosyncratic shocks that are not shared by the country to which it has set its currency