Question

What do fixed and floating exchange rates have in common, and why is the difference between them so significant?

Answer 1

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.

Both fixed and floating exchange rates signify an active monetary policy being pursued by the country's government or its central bank. Also the difference between the two exchange rate regimes is significant as both are applicable for different kinds of economies and thus countries must weigh the pros and cons of each before deciding on which one to pursue.

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.e. reducing the impact of economic shocks on domestic output and employment. Both types of exchange rate regime have their pros and cons, and the choice of the right regime may differ for different countries depending on their particular conditions. In practice there is a range of exchange rate regimes lying between these two extreme variants, thus providing a certain compromise between stability and flexibility.