What are floating and fixed exchange rates?

What is a floating exchange rate?

Also known as a flexible or self-correcting exchange rate, a floating exchange rate changes according to supply and demand. This means that any differences in regards to this factor will be corrected automatically in the market.

Put simply, if the demand for a currency is low then its value will also fall, making imports more expensive. Alternatively, if demand for a particular currency is high, then its value will increase.

When it comes to supply and demand, they can be impacted in a variety of ways, including interest rates, inflation, and foreign investment. All of these will have a big impact on the value of a currency. For example, if a country receives a lot of foreign investment from abroad, then the demand for its currency will increase and result in a rise in value. This is why a floating exchange rate is likely to fluctuate all of the time, as there are lots of different factors in play that can impact how an exchange rate is performing.

The reality is that no currency is solely floating or fixed. The majority of countries tend to use both elements of exchange rate types. In both instances, the central bank for that nation may intervene if necessary. Where floating exchange rates are concerned, this could happen when the exchange rate becomes too high or low.

However, if a country does prefer a floating exchange rate system, then interference from its central bank is a lot less likely. In theory, the exchange rate should self-correct.

What is a fixed exchange rate?

A fixed exchange rate, also known as a pegged exchange rate, is when the central bank of a nation sets a rate against the value of one or more major currencies. For example, in a lot of cases, this set rate will be determined against currencies like the US Dollar, Euro, or British Pound. This effectively means that if you frequently trade with a nation where a fixed exchange rate has been determined, you will always get the same exchange rate and value for your money.

This exchange rate type is popular in countries that want to give some stability to their own currency and make their trading finances more predictable and measurable. However, this does mean that the value of their own currency becomes reliant on the currency it is fixed (or pegged) to, as it will rise and fall with that particular currency.

The central bank will buy and sell its currency on the foreign exchange market in return for the currency it is fixed to. In order to minimise the risk of being too reliant on one fixed currency, the nation’s central bank may opt to spread this risk by fixing their currency to several others at different percentages. For example, a currency may be fixed at 60% to the US Dollar, 30% to the Euro, and 10% to the British Pound.

What are the advantages and disadvantages of floating exchange rates?

Unsurprisingly, there are both advantages and disadvantages associated with floating exchange rates. When it comes to choosing between a floating or fixed exchange rate, a country’s decision will ultimately be determined by its financial situation.

Here are the advantages and disadvantages of floating exchange rates.

Advantages of floating exchange rates:

• As the floating exchange rate moves independently, it doesn’t have to be monitored and managed to the extent of a fixed exchange rate. Currencies can be traded without any restrictions.

• Resources and cash flow are freed up thanks to a lack of regulation needed. Provides stability in the balance of payments.

• Lesser need for foreign currency reserves to defend the exchange rate. Therefore, reserves can be used elsewhere.

• Avoidance of higher import prices helps to avoid inflation.

Disadvantages of floating exchange rates:

• Highly volatile as they can be affected by unpredictable market conditions – caused by fluctuations in supply and demand.

• If a country is struggling economically, then a floating exchange rate may worsen its problems. For example, if its currency depreciates while experiencing high inflation.

• A lack of control over exchange rates may impact economic growth or recovery.

• Fluctuations in the exchange rate could deter foreign investors and traders.

What are the advantages and disadvantages of fixed exchange rates?

Similarly to floating exchange rates, there are advantages and disadvantages associated with fixed exchange rates.

Advantages of fixed exchange rates:

• Agreeing on a fixed exchange rate with another country will provide currency rate certainty to importers and exporters.

• If a country is suffering economically, it can protect itself from paying more by fixing itself to a more prosperous nation – helping create stability.

• A fixed exchange rate can also help with the flow of money from one country to another – making it a smoother process.

• Helps smaller countries keep inflation stable and avoid drastic devaluation of their currency.

Disadvantages of fixed exchange rates:

• High maintenance. The central bank needs to constantly monitor the market and intervene to prevent major impacts from economic changes. If not managed properly, this can be hugely expensive and lead to an economic crisis.

• If central banks want to make adjustments to the interest rates to boost the economy, they may not necessarily have the freedom to do so.

• The rebalancing and auto-correcting nature of a floating exchange rate is lost with a fixed rate. This makes it more complex.

• Requires a large number of reserves if the currency comes under pressure and needs support.

Which is better, a fixed or floating exchange rate?

There isn’t a concrete winner in this debate, as, at their core, neither rate is better than the other. As we mentioned earlier, the choice between a floating or fixed exchange rate will be determined by a country’s current financial situation.

A country will always choose the exchange rate type that suits them best. In most cases, this results in a hybrid model that uses certain elements from both exchange rate methods. You can find out more information about each country’s preferred approach to exchange rates here.

So, if you were left wondering at the start what a floating and fixed exchange rate is, then hopefully the definitions and pros and cons we have listed in this article have helped. For the latest exchange rates and fast, reliable international money transfers, check out the WorldRemit website.

Floating and fixed exchange rates: FAQs

Does the UK have a floating exchange rate?

Yes. The Bank of England does not set the exchange rate for the pound – this is instead decided by supply and demand. The UK has had a floating exchange rate since 1972, where the value of the pound has changed on any given day, depending on supply and demand.

Does China have a fixed exchange rate?

Unlike most major economies around the world, China does not have a floating exchange rate. Instead, it fixes its currency to the US Dollar. The yuan was pegged to the dollar at 8.28 for more than a decade starting in 1994.

Does the euro have a fixed or floating exchange rate?

Like a lot of leading nations globally, the exchange rate of the euro is free-floating. The European System of Central Banks has the power to intervene in the foreign exchange markets, as central banks do in other countries.

How does a fixed exchange rate control inflation?

A fixed exchange rate can help to lower inflation by inducing greater policy discipline and instilling greater confidence in the currency. It has been a long-held view that fixed, or pegged, exchange rate systems can be a successful anti-inflationary tool.

This communication is intended for marketing purposes only and does not constitute or provide legal, tax, investment or financial planning related advice.