The primary difference between a fixed and floating exchange rate is the underlying factor that affects a currency’s value. A fixed exchange rate is one where a currency is held to the value of a commodity or another currency. A floating exchange rate is one where a currency’s value is allowed to "float" or go up and down based on the supply and demand of the products and services transacted.
Supply and demand affects a floating exchange rate. The relationship between one currency and other currency or commodity defines a fixed exchange rate.
Historical Basis of Exchange Rates
Prior to 1971, most currencies were fixed. The U.S. dollar was held to the gold standard. The intent was to affix the dollar’s value to something that had actual value, such as gold. Fixed exchange rates provided a monetary anchor and reduced the risk of international transactions. This prevented the value of one of the currencies from fluctuating between the time the transaction was agreed upon and the time the transaction was fulfilled. Today, most currencies are based on the floating exchange rate.
Fixed Exchange Rate: Strengths and Weaknesses
A fixed exchange rate can be beneficial for some countries. Fixed exchange rate countries experience slower inflation and a reduced risk in international transactions. In addition, developing countries with fragile currency valuation are not subject to volatile exchange rates that could ruin a delicate economy. However, economic activity depends on the exchange rate.
This means that economic activity is held to its currency’s value. There is therefore less incentive for innovation in a fixed exchange rate society to add value by offering products and services to grow the economy.
Floating Exchange Rate: Strengths and Weaknesses
It is a general consensus among economists in developed nations that major currencies, including the dollar, euro, and yen, should be based on a floating exchange rate. Because they represent almost half of all global activity, they are not subject to the volatility of currencies from smaller economies.
Therefore, larger economies withstand the variability of the risk of international transactions. These economies grow at a rate determined by supply and demand of goods and services. Therefore, this growth trickles down and results in economic growth for smaller countries.
When Fixed Rate Exchange Countries Float
Fixed and floating exchange rates have advantages and disadvantages, and sometimes a country with a fixed exchange rate wants to move to a floating exchange rate. Adopting a flexible exchange rate requires a robust economy with checks and balances that prevent fiscal corruption. Sound fiscal and monetary policies should be present, governed by a central bank that monitors inflation and unemployment.
Steps can be taken to regulate these factors of production so that when there is downward pressure on the currency, external forces — such as interest rates, buying and selling of government securities, and bank regulations — can absorb some of the effects of a devalued currency in the short term.