4 min
Fixed vs Floating Exchange Rate: Key Differences, Pros & Cons Explained
- What Is a Floating Exchange Rate?
- What Is a Fixed Exchange Rate?
- Comparing Fixed and Floating Exchange Rates
- Pros and Cons of Each System
- Real-World Examples
- Which System Is Better?
The value of a country’s currency is crucial in shaping its economic interactions with the rest of the world. Countries generally adopt either a fixed or floating exchange rate system, each with its distinct approach to how the currency’s value is set and maintained.
What Is a Floating Exchange Rate?
In a floating exchange rate system, the price of a currency is free to fluctuate according to the forces of supply and demand on the foreign exchange market. Here, the currency’s value changes continuously, influenced by factors like trade flows, capital movements, interest rates, and geopolitical events. This system is seen as "self-correcting": if a currency weakens due to lowered demand, the cost of imports rises, encouraging consumption of domestically produced goods which can enhance the local economy and eventually stabilize the currency’s value. Most major economies, including the US dollar, euro, Japanese yen, British pound, and Australian dollar, operate with floating exchange rates. Central banks may occasionally intervene during extreme volatility but generally let market forces prevail.
What Is a Fixed Exchange Rate?
A fixed exchange rate, by contrast, is when a country pegs its currency’s value to that of a more stable and influential currency or a basket of currencies. The central bank commits to maintaining this peg by buying or selling currency as needed to keep the exchange rate within a narrow band. This system brings predictability and stability, which is attractive for trade and investment, but it requires the country to maintain large reserves of foreign currency to defend the peg. Smaller or trade-dependent economies often adopt fixed exchange rates—for example, island nations in the Caribbean peg their currency to the US dollar to stabilize operations heavily dependent on US dollar transactions. Morocco’s dirham is pegged to a basket comprised of 60% euro and 40% US dollar, offering a blend of stability and exposure to multiple economic regions.
Comparing Fixed and Floating Exchange Rates
| Aspect | Fixed Exchange Rate | Floating Exchange Rate |
|---|---|---|
| Currency Value Determined By | Central bank intervention to maintain a peg | Market forces of supply and demand |
| Exchange Rate Stability | High—value kept within a narrow range | Variable—can fluctuate significantly |
| Monetary Policy Flexibility | Limited—policy tools constrained to defend the peg | High—central banks can independently adjust policies |
| Reserves Required | Substantial foreign reserves to maintain peg | Minimal foreign reserves needed |
| Trade and Investment Impact | Predictable—fosters stable trade and investment | Can be uncertain—volatility can deter traders/investors |
| Risk of Crises | Vulnerable to speculative attacks if peg doubted | Vulnerable to volatility but less prone to crises |
| Typical Usage | Often developing or smaller economies | Larger, diversified, developed economies |
Pros and Cons of Each System
Fixed exchange rates carry the advantage of stability and predictability, allowing businesses and governments to plan financial activities with greater confidence. They help curb inflation by anchoring the currency to a stable benchmark. However, this system requires a commitment to maintain the peg, sometimes at the expense of independent monetary policy. Central banks may exhaust reserves defending the peg during economic shocks, leading to sudden devaluations or crises.
Floating rates afford countries greater freedom to tailor monetary policy to economic conditions, which can help manage growth and inflation more effectively. The automatic adjustment of currency values helps economies respond to external shocks. However, floating currencies can experience significant volatility, introducing uncertainty that complicates trade and raises risks for investors and businesses.
Real-World Examples
Hong Kong’s dollar is a prime example of a fixed exchange rate pegged tightly to the US dollar, supporting the city’s role as an international financial center. On the other hand, major global currencies like the US dollar, euro, Japanese yen, and British pound float freely, reflecting their large, resilient economies with deep financial markets. Morocco blends systems by pegging its dirham to a basket of major currencies, mitigating risks associated with a single currency anchor.
The Swiss franc famously illustrated the challenges of fixed exchange rates when it was pegged to the euro between 2011 and 2015 to curb excessive appreciation, only to later remove the peg with significant market disruption.
Which System Is Better?
Neither fixed nor floating exchange rates are superior in all situations; rather, the best choice depends on an individual country’s economic structure, stability, trade dependency, and policy goals. Developing or small, trade-dependent economies tend to prefer fixed rates to build credibility and promote trade, while mature economies with robust financial markets typically opt for floating rates to better manage domestic monetary policy and respond to global economic fluctuations.
