Fixed vs floating exchange rates difference

Fixed and floating exchange rates are two systems used to determine the value of a currency relative to others. Here’s a breakdown of their key differences:

Fixed Exchange Rates
– **Definition**: A fixed exchange rate (or pegged exchange rate) is one where a country’s currency value is tied or pegged to another major currency, such as the US dollar or gold.
– **Stability**: Provides greater stability in international prices, making it easier for businesses to plan and invest.
– **Government Intervention**: Requires the government or central bank to intervene in the foreign exchange market to maintain the pegged value, often by buying/selling currency.
– **Examples**: Countries like Saudi Arabia and the United Arab Emirates have fixed exchange rates to the US dollar.

Floating Exchange Rates
– **Definition**: A floating exchange rate is determined by the market forces of supply and demand relative to other currencies, without direct government or central bank intervention.
– **Volatility**: Can be more volatile, with rates fluctuating based on economic indicators, market sentiment, and geopolitical events.
– **Automatic Adjustment**: Allows for automatic adjustments to trade imbalances, as currency values can fluctuate to reflect economic conditions.
– **Examples**: Major currencies like the US dollar, euro, and Japanese yen typically operate under a floating exchange rate system.

Key Differences
| Aspect | Fixed Exchange Rate | Floating Exchange Rate |
|—————————|—————————————-|——————————————-|
| **Determination** | Pegged to another currency | Determined by market forces |
| **Stability** | More stable and predictable | More volatile |
| **Government Role** | Active intervention required | Minimal intervention |
| **Adjustment** | Slow adjustments to economic changes | Rapid adjustments based on market dynamics |
| **Trade Balance** | May lead to imbalances | Self-correcting through currency fluctuations |

Conclusion
Choosing between fixed and floating exchange rates depends on a country’s economic goals, stability needs, and external trade relationships. Each system has its advantages and challenges, influencing trade, inflation, and economic policy.