What is the Exchange Rate?
There are various types of exchange rates that are commonly prevalent in the market, but the most commonly used exchange rate systems are the fixed exchange rate and the flexible exchange rate systems. Now, the question is what is the exchange rate?
The exchange rate means the rate that is used for converting the currency from one country to another country. So, there are two types of exchange rate - fixed exchange rate and flexible exchange rate. The difference between fixed exchange rate and flexible exchange rate is the topic of concern here. Other than this, we will excavate what is fixed exchange rate system and flexible exchange rate system. Also, we will discuss the difference between fixed and floating exchange rates.
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Difference Between Fixed and Flexible Exchange Rate
The main topic of concern here is the difference between fixed and flexible exchange rates. So, A fixed exchange rate represents a nominal exchange rate that is set firmly by the monetary authority, this is with respect to the foreign currency. While in contrast, a floating exchange rate is determined by the foreign exchange markets which depend on the demand and supply, and this generally fluctuates quite constantly.
To know the difference vividly, first, we are going to discuss fixed and flexible exchange rates thoroughly.
Fixed and Flexible Exchange Rate
A fixed exchange rate system is defined as the exchange system where the exchange rate is fixed by the government or by any monetary authority. This is not determined by the market forces.
The flexible exchange rate system is the exchange system where the exchange rate gets dependent upon the supply and the demand of money in the market. In a flexible exchange rate system, the value of the currency operating in the market is allowed to fluctuate freely as per the changes in the demand and supply of the foreign exchange.
Let us discuss the two exchange rates point-wise.
Fixed Exchange Rate
The fixed exchange rate is being officially fixed by the government or by any competent authority, but this is not fixed by the market forces.
In the case of a fixed exchange rate, the government and central bank attempt to keep the value of the current flowing in the national market fixed against the value of other currencies flowing in the international market.
The value determined by the currency was set in terms of gold and by the exchange rate which was fixed according to the gold value of the currencies which have to be exchanged.
Like for example in India, a currency price is fixed as an official price of its currency in the form of reserve which is issued by the central bank.
Once the rate is determined, the central bank undertakes this to buy and sell the foreign exchange and the private purchase and sales are being postponed.
While the rate can be changed by the apex bank that is RBI.
Flexible Exchange Rate
A flexible exchange rate can also be called the floating exchange rate.
In a flexible exchange rate, the rate is being set according to the demand and supply of the market forces.
The economic condition of the country will determine the flexible exchange rate.
A flexible exchange rate is determined by taking care of other currency which means the higher the demand of the particular currency, the higher will be the exchange rate.
If an economy is very strong the flexible exchange rate is higher and if the economy is weak the exchange rate will be below.
The value of the currency is fluctuated or is shifted freely according to the demand and supply of the international exchange.
Fixed Exchange Rate Vs Flexible Exchange Rate
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What is the Difference Between a Fixed Exchange Rate and a Floating Exchange Rate?
The floating exchange rate is nothing but another name for flexible exchange rates.
A fixed exchange rate denotes the nominal exchange rate which is set firmly by the monetary authority or the government with respect to the foreign currency. In contrast to this, a floating exchange rate is determined in the foreign exchange markets. The rates will depend on the demand and supply of currency which generally fluctuates constantly.
Effects to the Nation – Advantages of Floating Exchange Rate
A fixed exchange rate regime normally reduces the transaction costs that are implied by the exchange rate uncertainty, this might discourage international trade and other investment, and will provide a scenario of low-inflationary monetary policy. On the other hand, autonomous monetary policy or floating exchange rate is lost in this particular regime, as the central bank must keep intervening in the foreign exchange market in order to maintain the exchange rate at the officially set level. The Autonomous monetary policy is thus playing a big advantage being the floating exchange rate.
FAQs on Difference Between Fixed and Flexible Exchange Rate
1. What is a fixed exchange rate system in the context of the CBSE Class 12 syllabus?
A fixed exchange rate system, also known as a pegged exchange rate, is a regime where a country's government or central bank ties its official currency exchange rate to another country's currency or a price of gold. The purpose is to maintain the country's currency value within a very narrow band. The central bank controls the rate by buying or selling its own currency in the foreign exchange market in exchange for the currency to which it is pegged.
2. What is a flexible exchange rate system and how is it determined?
A flexible exchange rate system, also known as a floating exchange rate, is one where the currency's value is determined by the forces of supply and demand in the foreign exchange market. Unlike a fixed system, there is no direct intervention from the country's central bank to control the rate. The value of the currency fluctuates constantly based on factors like trade, investment flows, and economic stability.
3. What is the primary difference between a fixed and flexible exchange rate?
The primary difference lies in how the currency's value is determined. In a fixed system, the exchange rate is officially set (pegged) by the government or central bank. In a flexible system, the exchange rate is determined by the free market through the interaction of supply and demand for the currency, leading to constant fluctuations.
4. What are the main advantages of adopting a fixed exchange rate system?
A fixed exchange rate system offers several key advantages:
Stability and Certainty: It eliminates exchange rate fluctuations, which reduces uncertainty for international trade and investment.
Inflation Control: It can force a country to follow disciplined monetary policies to keep its currency's value stable, thereby controlling inflation.
Prevents Speculation: A credible fixed rate discourages speculative activities that can destabilise a currency.
5. Why might a country prefer a flexible exchange rate system despite the uncertainty?
A country might prefer a flexible exchange rate system for several strategic reasons:
Automatic Adjustment: It allows for automatic correction of a country's balance of payments disequilibrium. For example, a deficit can lead to currency depreciation, making exports cheaper and imports more expensive, which helps to correct the deficit.
Independent Monetary Policy: The central bank is free to use monetary policy to address domestic issues like unemployment and inflation without being tied to maintaining a specific exchange rate.
No Need for Large Reserves: The central bank does not need to hold large foreign exchange reserves to defend a fixed rate.
6. How does a 'managed floating' exchange rate system differ from a purely flexible one?
A 'managed floating' system is a hybrid of the fixed and flexible systems. While the exchange rate is primarily determined by market forces (like a flexible system), the central bank intervenes periodically to buy or sell foreign currencies. This intervention is not to maintain a fixed peg, but to moderate excessive fluctuations or influence the exchange rate in a desired direction. This is often called a 'dirty float', as opposed to the 'clean float' of a purely flexible system.
7. Which exchange rate system does India currently follow and why?
Currently, India follows a managed floating exchange rate system. The value of the Indian Rupee (INR) is largely determined by market demand and supply. However, the Reserve Bank of India (RBI) actively monitors the market and intervenes when it perceives excessive volatility. This approach was adopted to gain the benefits of a flexible system, like automatic adjustments and monetary policy independence, while still retaining the power to prevent extreme currency swings that could harm the economy.
8. How does government intervention impact currency value in a fixed versus a flexible system?
The role of government intervention is fundamentally different in the two systems.
In a fixed system, intervention is the core mechanism. The central bank must constantly buy or sell currency to counteract market pressures and maintain the pegged value. This is known as pegging operations.
In a purely flexible system, there is theoretically no government intervention. The market is left to self-correct. In practice, as with India's managed float, intervention is used as a tool to manage volatility rather than to enforce a specific rate.
