Question

List the five variables that explain why a country would choose to have a fixed exchange rate rather than a floating exchange rate.

Answer 1

Solution

1.Quantum of it's Exports - If a country exports more than it imports,it may have a tendency to opt for a Fixed exchange rate because it has a trade surplus / positive trade balance with other countries.So,it will be more effected than other countries if it's currency exchange rate becomes volatile.So,the govt.wants to control the volatility of it'e exchange rate by pegging it with another base currency which is generally considered stable.

Ex :Countries like China ,Saudi Arabia etc.,

2.Financial Stability of the country - If the financial stability of the country is already good and the country doesn't want that to be effected by the change in its currency exchange rate then the Central Govt.will opt for a Fixed exchange rate.

3.Type of Economic Policy / Political system in the country. - Generally,the countries which have opened up their economies for trade with the world follow the policy of floating interest rate in contrast with the comparatively closed economies which opt for a fixed exchange rate.

Also generally the democratic countries where the laws are liberal in most aspects tend to pt for a floating exchange rate system

4.Reserves of the country - If a country has very huge reserves then it will prefer going for a fixed exchange rate system because it can manipulate / control it's currency exchange rate through market operations (buying /selling it's currency / pegged countries' currency in the foreign exchange market)

5.Composition of Trading partners - If a country does a huge trade specially with a country and the if the very same country's currency is also stable ,then it generally opts for a fixed exchange rate system and pegs it's currency against that country.

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