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The Difference between Floating and Fixed Exchange Rate Systems

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A currency exchange system in which the value between currencies of each country is determined by the supply-demand relationship of the foreign exchange market. It is often called a floating exchange rate system for short. The opposite of this is the fixed exchange rate system.

The floating exchange rate system

It is a system that freely fluctuates the exchange rate according to the supply and demand of the foreign exchange market known as a “float system”. The floating exchange rate system has the advantage that economic conditions are reflected in the exchange rate and the discretion of monetary policy increases, but it has the disadvantage that the exchange rate fluctuates sharply, such as fluctuations due to speculative money.

The fixed exchange rate system

It is a system that fixes the exchange rate to a specific level or limits fluctuations to a minimum known as a “peg system”. The fixed exchange rate system is because there are no market fluctuations due to imports and exports. The fixed exchange rate system includes the “dollar peg” that keeps the exchange rate between the home currency and the US dollar at a fixed rate, notably:

 

  • Due to a depreciated currency, it is easier to adapt to external demand.
  • A discretionary monetary policy.
  • Markets will be reflective of the economic situation.
US Dollar
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Benefits of a fixed exchange rate

The currency of a country with a small economy has a small trading volume; there is a risk that the rate will move violently if it is set to a floating exchange rate. If it is too unstable, you won’t be able to trade with confidence, so to avoid that, we’re suppressing fluctuations in exchange rates.

World Exchange rate system:

The world exchange rate system is roughly divided into two, the “floating exchange rate system” and the “fixed exchange rate system”. The United States has the former floating exchange rate system, and the exchange rate, which indicates the ratio when exchanging two currencies, is naturally determined in the market. In other words, when exchanging the US currency dollar for the Canadian Dollar, the exchange rate is determined by the power relationship between the demands of “I want to buy the Canadian Dollar” and “I want to buy the US dollar”.

Characteristics of floating exchange rate system

  • Fiscal policy:

If a country with a closed economy increases its fiscal spending to improve national income, interest rates will rise at the same time as national income will increase. However, in the case of an open economy system, the interest rate of a small country exceeds the world standard interest rate, so international capital will buy the currency of the small country.

In a floating exchange rate system, the inflow of international capital does not result in an increase in the domestic money supply, but only in currency appreciation. Although it seems strange from the conventional image that the inflow of international capital creates a bubble, the money supply does not increase and the appreciation of the currency puts deceleration pressure on the economy.

  • Financial policy:

If a country with a closed economy implements monetary easing to improve national income, interest rates will fall at the same time as national income and money supply will increase. Furthermore, in the case of an open economy system, the interest rate of a small country is lower than the world standard interest rate, so international capital sells the currency of the small country.

In a floating exchange rate system, the outflow of international capital does not result in a decrease in the domestic money supply but results in a currency depreciation effect.

The United States Dollar
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Characteristics of Fixed exchange rate system:

  • Fiscal policy:

If a country with a closed economy increases its fiscal spending to improve national income, interest rates will rise at the same time as national income will increase. However, in the case of an open economy system, the interest rate of a small country exceeds the world standard interest rate, so international capital will buy the currency of the small country. In the fixed exchange rate system, the inflow of international capital does not bring about a currency appreciation, but brings about an increase in the domestic money supply and lowers interest rates. This decline in interest rates will reduce the crowding effect and increases national income. Interest rates will fall until they match the world standard interest rate, and the crowding effect will disappear.

  • Financial policy:

If a country with a closed economy implements monetary easing to improve national income, interest rates will fall at the same time as national income and money supply will increase. Furthermore, in the case of an open economy system, the interest rate of a small country is lower than the world standard interest rate, so that international capital sells the currency of the small country. In the fixed exchange rate system, the outflow of international capital does not bring about currency depreciation, but causes a decrease in the domestic money supply and raises interest rates. This rise in interest rates will reduce private investment and national income. Interest rates will rise until they match global interest rates, offsetting the effects of monetary policy by 100%.

The Main Points of the Floating Exchange Rate System

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The foreign exchange rate system can be broadly divided into two systems: the fixed exchange rate system and the floating exchange rate system. First, let us review a little about what the fixed exchange rate system is.

The fixed exchange rate system was a system in which the dollar and yen exchange rate (price) was firmly “fixed” to “1 dollar = how many Canadian dollar(s)”. Under this system, a predetermined amount of money is available, so the world’s money transactions can be carried out with peace of mind.

However, this system relied on the power of the United States, a country in an “absolute position” of power both politically and economically. In other words, the US dollar as the American currency was used as the center of the world’s currency (the key currency), and they were firmly linked. This also combined the value of the dollar with gold in order to make the US domestic currency the international currency used for world trading, and many countries decided to use the dollar as a key currency.

What is the mechanism of the floating exchange rate system?

Every system has pros and cons, the same applies to the floating exchange rate system, which is the center of the world economy. Not surprisingly, the world economy, which was based on a fixed exchange rate system, adopted a floating exchange rate system in order to clear the deadlock, but the world generally did not agree that the floating exchange rate system was the best system. Therefore, let us consider the positive points of the floating exchange rate system.

Exchange Rate
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 Benefits of Floating exchange rate system

Major countries in the world decided to abandon the “fixed exchange rate system” and shift to the “floating exchange rate system”. Floating exchange rates can be broadly divided into two forms. The first is a free-floating exchange rate system – in the foreign exchange market, the exchange rate is completely determined by the supply and demand of foreign exchange. The second is a managed floating exchange rate system – this is a system that assumes that the currency authorities will intervene in the foreign exchange market and manipulate the exchange rate in order to prevent the exchange rate from deviating significantly from the existing standards.

  • Under the floating exchange rate system, it is possible that the external imbalance of a country will be automatically resolved. For example, when the Canadian balance of payments goes into the black, a large inflow of dollars will occur in the Canadian foreign exchange market. As a result, the dollar will weaken and the Canadian dollar will appreciate, and this appreciation will curb the demand for Canadian goods from overseas, resulting in a decrease in Canadian exports. In other words, it is thought that the large surplus of Canadian balance of payments in the early stages, will be automatically eliminated under the floating exchange rate system. This is called the automatic adjustment mechanism of the floating exchange rate system, and it is considered a great merit of the floating exchange rate system.

 

  • With a floating exchange rate system, speculative capital inflows may be small. This speculative inflow of capital means foreign investment coming in to take advantage of sudden fluctuations in exchange rates. For example, global “investment funds” and “institutional investors” who manage huge amounts of money inject a large amount of money at once in order to seek profit from fluctuations in the exchange rate of a certain country. This speculative capital is also called hot money.

 

  • Fluctuations in foreign exchange rates will theoretically automatically balance the payments of a country, so the government of that country will not need to worry about the balance of payments. In other words, the advantage of the floating exchange rate system is that the government of the home country should instead focus on overcoming the inward equilibrium (inflation and deflation) in the home country.

 

  • Since the exchange rate is automatically adjusted by the foreign exchange rate, the currency authorities of a country do not need to have the funds to return the exchange rate to the way it should be, that is, there is no need for intervention funds. Therefore, one of the advantages of the floating exchange rate system is that you do not need to have much in the way of foreign currency reserves.

There are other advantages as well, but experts who have defended the floating exchange rate system have said that the floating exchange rate system is, so to speak, “all good things”. However, it cannot be said that only “good things” are happening all the time, and the advantages of the floating exchange rate system mentioned above are not particularly effective. The world also seems to be in turmoil in comparing both systems.