Differentiate between floating currency exchange rate and fixed currency exchange rate

People who do business internationally should be aware of exchange rates and how they work exactly. Let’s try to understand about floating currency exchange rate and fixed currency exchange rate.

Floating currency exchange rate

Floating currency exchange rate depends on demand and supply. If demand for currency is high then value increases and if demand for currency is low then value decreases. This exchange rate affects a country’s trade position internationally.

Advantages of the floating currency exchange rate are as follows −

• Change of internal policy.
• Large reserves are not needed.
• Central bank has less power.

Disadvantages of the floating currency exchange rate are as follows −

• Uncertainty.
• Volatility is high.
• Exchange rate risk is high.

Fixed currency exchange rate

Fixed currency exchange rates are maintained by the central bank and these are also called pegged rates. These are found mainly in the Middle East and Africa. Central bank links domestic currency to another country’s currency and makes sure the rate will not change.

Most countries peg their currency to US $, some may peg to EURO etc. central intervene and keep foreign reserves at high level. These rates are used to adjust market fluctuations. Release or absorption of funds in or out is powered by the central bank. Maintaining a certain level of foreign reserves is important in managing.

Advantages of the fixed currency exchange rate are as follows −

• Stable currency value.
• Lower inflation rate.
• Encourages investment.
• Rate is maintained by the central bank.

Disadvantages of the fixed currency exchange rate are as follows −

• Central bank must intervene very often.
• No monetary independence.
• Sometimes expensive to maintain.