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 Hedging?
Ans. Hedging is a way of investing to reduce the risk of adverse pricing movements in an asset. A hedge consists of all that is taking an offsetting or an opposite position in a security that is the same as, or which is related to, the one the investor already has. Hedging is a defensive move, which is designed to limit the loss.
2. Which Countries Have a Fixed Exchange Rate? What Does India Have?
Ans. The four countries which maintain a fixed exchange rate system: Fiji, Kuwait, Morocco, and Libya.
Currently, India follows a floating exchange rate system.
3. In Which Economy a Fixed and a Floating Exchange Rate Must Operate?
Ans. With the prudent domestic type policies experienced in a place, a floating exchange rate system will operate well. Fixed exchange systems are most appropriate when a country needs to be in a force of itself to a more prudent monetary policy course.
