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Floating and fixed foreign exchange rates

Economics notes

Floating and fixed foreign exchange rates

Foreign exchange rates can be classified into floating or fixed exchange rate systems. In a floating exchange rate system, the value of a currency is determined by market forces of supply and demand in the foreign exchange market. The exchange rate fluctuates freely based on various factors, such as economic conditions, interest rates, inflation differentials, and market sentiment. In contrast, in a fixed exchange rate system, the value of a currency is fixed or pegged to another currency, a basket of currencies, or a commodity. Governments or central banks intervene in the foreign exchange market to maintain the fixed exchange rate by buying or selling their own currency. Each exchange rate system has its advantages and disadvantages. Floating exchange rates allow for greater flexibility and automatic adjustment to market conditions but can be subject to volatility and uncertainty. Fixed exchange rates provide stability and certainty for trade and investment but require active management and control by authorities. Understanding floating and fixed exchange rates helps businesses, policymakers, and individuals navigate the global financial system, assess currency risk, and make informed decisions regarding international transactions.

What is the difference between floating and fixed foreign exchange rates?

In a floating exchange rate system, currency values fluctuate based on market forces, while in a fixed exchange rate system, governments or central banks intervene to maintain a specific exchange rate.

How does a floating exchange rate system promote economic stability?

A floating exchange rate system can promote economic stability by allowing currency values to adjust based on market forces, facilitating automatic adjustments to external imbalances and reducing the need for constant intervention.

What are the advantages and disadvantages of a fixed exchange rate system?

A fixed exchange rate system can provide stability, reduce exchange rate risk, and promote trade, but it can limit monetary policy flexibility, require interventions to maintain the peg, and potentially lead to imbalances and speculative attacks.

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