Why is fixed exchange rate better?
Fixed rates provide greater certainty for exporters and importers. Fixed rates also help the government maintain low inflation, which, in the long run, keep interest rates down and stimulates trade and investment.
The advantages of a fixed exchange rate include:
Providing greater certainty for importers and exporters, therefore encouraging more international trade and investment. Helping the government maintain low inflation, which can have positive long-term effects such as keeping down interest rates.
Fixed exchange rates work well for growing economies that do not have a stable monetary policy. Fixed exchange rates help bring stability to a country's economy and attract foreign investment. Floating exchange rates work better for countries that already have a stable and effective monetary policy.
| Fixed Pros | Fixed Cons |
|---|---|
| Enable the currency's value to remain stable | Central bank must intervene often |
| Can help lower inflation which encourages investment | Country loses monetary independence |
| The Central Bank has the power to maintain rate | Can be expensive to maintain |
A fixed exchange rate helps to ensure the smooth flow of money from one country to another. It helps smaller and less developed countries to attract foreign investment. It also helps the smaller countries to avoid devaluation of their currency and keep inflation stable.
Probably the best reason to adopt a fixed exchange rate system is to commit to a loss in monetary autonomy. This is necessary whenever a central bank has been independently unable to maintain prudent monetary policy, leading to a reasonably low inflation rate.
An advantage of a fixed exchange rate system is that governments are not required to constantly intervene in the foreign exchange market to maintain exchange rates within specified boundaries.
Disadvantages of a Fixed Exchange Rate
Lack of Monetary Policy Flexibility: Countries lose the ability to set their own interest rates and conduct independent monetary policy, as they must focus on maintaining the peg.
Flexible exchange rates offer automatic adjustments and monetary policy independence but can result in exchange rate volatility. Fixed exchange rates provide stability and predictability but limit policy autonomy and can be vulnerable to speculative attacks.
Fixed rates provide an anchor for countries with inflationary tendencies. By maintaining a fixed rate of exchange to the dollar (or some other currency), each country's inflation rate is “anchored” to the dollar and thus will follow the policy established for the dollar.
Why do fixed exchange rates fail?
If there are lots of imports or exports, the 'price' of the currency does not change. This means fixed exchange rates fail to adjust for changes in competitiveness over time.
A fixed exchange rate is a regime imposed by a government or central bank which ties the official exchange rate of the country's currency with the currency of another country or the gold price. A fixed exchange rate system has the aim of keeping the value of a currency within a narrow band.
- Aruba.
- The Bahamas.
- Bahrain.
- Hong Kong.
- Iraq.
- Saudi Arabia.
Fixed exchange rates reduce foreign exchange risk for companies with cross border trade. The major disadvantage of fixed exchange rate system is that it establishes a direct link between domestic and foreign inflation and employment.
A fixed exchange rate, often called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold.
There are two types of currency exchange rates—floating and fixed. The U.S. dollar and other major currencies are floating currencies—their values change according to how the currency trades on forex markets. Fixed currencies derive value by being fixed or pegged to another currency.
Banks offer floating-rate loans at lower cost because these loans help them match the interest-rate exposure of their own short-term liabilities.
A fixed exchange rate denotes a nominal exchange rate that is set firmly by the monetary authority with respect to a foreign currency or a basket of foreign currencies. By contrast, a floating exchange rate is determined in foreign exchange markets depending on demand and supply, and it generally fluctuates constantly.
Many countries stabilise their currencies by pegging them to the US dollar, which is often regarded as the most stable currency in the world. Currency pegs can promote trade and raise real incomes, but they can also lead to persistent trade deficits.
Using a floating currency can be considered a fiscal benefit when the economy is strong and fiscal policy is sound. But, if market sentiment towards the government and its monetary policy is weakened, it could lead to a devaluation of its currency.
What is a major advantage of a floating exchange rate quizlet?
An advantage of freely floating exchange rates is that a country with floating exchange rates is more insulated from unemployment problems in other countries.
What are the advantages of floating exchange rates? - Freedom to use monetary policy for other aims.
Advantages and Disadvantages: Fixed exchange rates provide stability and reduced transaction costs but limit monetary policy flexibility. Flexible exchange rates allow for automatic adjustments and monetary policy independence but can introduce exchange rate volatility.
Shock Absorption: Free-floating exchange rates allow countries to absorb external economic shocks more effectively. If a country faces an economic crisis, such as a recession, the exchange rate can act as a shock absorber by helping to rebalance the economy.
China pegged its currency from 1997 to 2005 to the U.S. dollar but since has managed its currency against a basket of currencies. The effect of the peg and the low currency is that Chinese exports are cheaper and, therefore, more attractive compared to those of other nations.
