Open economies in a global market are confronted with three objectives - stabilising the exchange rate, enjoying international capital mobility and engaging in a monetary policy tailored for domestic goals.
Unfortunately, desirable as these are, they are contradictory. Fixed forex rates stabilise the rate while engaging in domestically-oriented monetary policy, these don't coincide with enjoying international capital mobility, which is where floating forex rates come in.
Fixed forex rates
A fixed foreign exchange rate is when a currency's value is pegged to the value of another currency, group of currencies, or another asset, like gold. Fixed rates were used globally from 1944 to 1973, but now fixed rates are mainly used by small countries with economies that are largely dependent on foreign partners.
Fixed exchange rates are infrequently evaluated for political and economic reasons, either being revaluated or devaluated. A devaluation in a fixed rate lowers the value of the fixed currency, making exports more attractive to foreign investors as they become cheaper when their value is converted into the investors' currencies. This also discourages imports as imported goods become more expensive due to the forex rate, the ultimate goal being to increase trade surpluses while decreasing trade deficits.
A revaluation raises the value of the fixed currency, causing the opposite scenario to occur.
Floating forex rates
Floating foreign exchange rates are when a currency's value changes depending on factors in the forex market, such as the currency's economy, investor sentiment, politics, inflation and interest rate derivatives.
This is the most common regime for major economies with two variants: free floating currencies and managed floating currencies.
The value of free floating currencies is solely determined by forex market forces and can fluctuate greatly, providing opportunities for traders to profit on rising and falling currency values.
Managed floating currencies are allowed to float to a certain extent, and will be reined in by the central bank if it travels too far from ideal levels.
That being said, every floating rate is managed, at least slightly. If a currency goes too far off course, that country's central bank will respond by changing interest rates or by buying and selling large amounts of currency to bring its currency back to acceptable levels.
Fixed vs. Floating forex rates
Fixed exchange rates benefit from reduced risks in international trade and investment as international buyers and sellers can agree to a price that won't be vulnerable to forex rate changes. Fixed rates can introduce stricter economic management, keeping inflation under control, and they can also reduce speculation, which can be destabilising to less-established economies.
However, the disadvantages of fixed rates are that there is no automatic balance of payments between nations without government interference; large holdings of foreign exchange reserves are necessary to maintain the fixed rate; the need to maintain the exchange rate can dominate monetary policy, which may be better focused on other things; and fixed exchange rates can be unstable, resulting in different rates of inflation causing imbalances of the levels of competitiveness between different countries.
Countries with floating exchange rates benefit from allowing the market to quickly respond to economic events, as opposed to waiting for the central bank's reaction. As the forex market is open 24-hours a day, free floating currencies can react very quickly to significant news. This also results in automatic correction in balance of payments adjustments as the exchange rates adjust to balance supply and demand.
As this will be taken care of automatically, governments should have more time to devote policy to other matters.
As floating rates change automatically, they don't suffer from international relations crises that can plague countries with fixed foreign exchange rates when pressure mounts on a currency to devalue or revalue.
And countries with floating exchange rates can have lower foreign exchange reserves.
However, floating exchange rates result in instability and uncertainty when it comes to international trade, as fluctuations can result in changing prices for imports and exports. This uncertainty can also lead to a lack of foreign investment. Having said that, this risk can be hedged by trading with forward transactions.
Floating exchange rates can result in undisciplined economic management as inflation is not punished, and governments may follow inflationary economic policies.
However, the downside of this is that severe shocks can cause a currency to plummet, magnifying the economic damage. And, as speculation is higher in floating exchange rate regimes, there is more uncertainty for forex traders and investors. A floating exchange rate can also cause inflation by allowing import prices to rise as the exchange rate falls.
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