The key difference between fixed and floating exchange rate is that fixed exchange rate is where the value of a currency is fixed against either the value of another currency or to another measure of value such as of a precious commodity whereas floating exchange rate is where the value of the currency is allowed to be decided by the foreign exchange market mechanism i.e. by demand and supply. With the increase in international trade in terms of both volume and value, the effects of exchange rates are vital for businesses to consider. Exchange rates are affected by a number of factors such as interest rates, inflation rates and government debt.
CONTENTS
1. Overview and Key Difference
2. What is Fixed Exchange Rate
3. What is Floating Exchange Rate
4. Side by Side Comparison – Fixed vs Floating Exchange Rate
5. Summary
What is Fixed Exchange Rate?
Fixed exchange rate is a type of exchange rate regime where the value of a currency is fixed against either the value of another currency or to another measure of value, such as gold. The objective of a fixed exchange rate is to maintain the value of a country’s currency within an intended limit. Fixed exchange rate is also referred to as a ‘pegged exchange rate’.
With the steady growth in globalization, countries increasingly enter into business transactions with other countries. Entering into transactions and the delivery of goods or services will occur at different points in time. If exchange rates vary significantly within this period, it may not be beneficial to the company. Therefore, having a stable exchange rate assists in better forecasting of costs and revenues.
Many countries choose to peg their currency to insulate themselves from market fluctuations and to maintain the international competitiveness of their exports. Having a depreciating currency is advantageous in terms of exports since the exports will be cheaper in the international market. As a result, the economy will not be affected by the constant fluctuation of floating exchange rates. Currency pegging is an expensive exercise where the country has to purchase local currency using foreign currency reserves when the value of the currency drops below the peg. Most countries have pegged their currencies to the US dollar which itself is fixed to gold and is the reserve currency in the world.
Table 1: Countries who have pegged currencies to US Dollar
What is Floating Exchange Rate?
Also referred to as ‘fluctuating exchange rate’, floating exchange rate is a type of exchange rate regime in which a currency’s value is allowed to fluctuate in response to foreign exchange market mechanism i.e. by the demand and supply for the respective currency. The currencies of most of the world’s major economies were allowed to float freely following the collapse of the Bretton Woods system in 1971 (a monetary management system established to maintain financial relations among the United States, Canada, Western Europe, Australia and Japan).
By the use of a floating exchange rate, countries can maintain their own economic policies since their currency is not affected by the changes in another currency or a commodity. Georgia, Papua New Guinea, and Argentina are a few examples of countries that use a floating exchange rate system. Floating exchange rates are subjected to high transaction and translation risks. In order to mitigate such currency risks, many organizations use hedging techniques such as forward contracts, futures contracts, options, and swaps.
Figure 01: Floating exchange rates are decided by the foreign exchange market mechanism
What is the difference between Fixed and Floating Exchange Rate?
Fixed vs Floating Exchange Rate |
|
| Fixed exchange rate is where the value of a currency is fixed against either the value of another currency or to another measure of value such as of a precious commodity. | Floating exchange rate is where the value of the currency is allowed to be decided by demand and supply. |
| Use of Foreign Currency Reserves | |
| Foreign currency reserves should be maintained to practice a fixed exchange rate regime | With a floating exchange rate, foreign currency reserves can be maintained at a reduced level. |
| Hedging | |
| There is no need to hedge currency risks if the country is using a fixed exchange rate. | With floating exchange rate, hedging should be used to mitigate currency risks. |
Summary- Fixed vs Floating Exchange Rate
The difference between fixed and floating exchange rate mainly depends on whether the value of a currency is controlled (fixed exchange rate) or allowed to be decided by the demand and supply (floating exchange rate). The decision as to whether to practice a fixed or floating exchange rate regime is taken by the government. While fixed exchange rate is advantageous in terms of forecasting business transactions, this is a costly method of maintaining the exchange rate. Fluctuating exchange rate does not have this limitation. However, it is difficult to incorporate it in financial decision making due to its inherent risk.
References
1. Zucchi, CFA Kristina. “Top Exchange Rates Pegged To The U.S. Dollar.” Investopedia. N.p., 02 Sept. 2016. Web. 04 Apr. 2017.
2. “Fixed Exchange Rate.” Investopedia. N.p., 09 Oct. 2015. Web. 04 Apr. 2017.
3. “Floating Exchange Rate.” Investopedia. N.p., 24 July 2015. Web. 04 Apr. 2017.
4. “IMF finds more countries adopting managed floating exchange rate system.” Nikkei Asian Review. N.p., 19 Aug. 2014. Web. 04 Apr. 2017.
5. Amadeo, Kimberly. “Why Countries “Peg” Their Currency to the Dollar.” The Balance. N.p., n.d. Web. 04 Apr. 2017.
Image Courtesy:
1. “Mechanism of Fixed Exchange Rate System” By Sridevi Tolety – Own work (CC BY-SA 3.0) via Commons Wikimedia