Question

What is the difference between fixed and flexible rates of exchange?

Hint:

Fixed exchange rates are controlled by the government or central bank, while flexible exchange rates fluctuate based on market forces.

Answer 1

Step 1: Defining Fixed Exchange Rates:
A fixed exchange rate is a system where a country’s currency value is tied or pegged to another major currency, like the US dollar or a basket of currencies. The central bank or government intervenes in the foreign exchange market to maintain the fixed value of the currency. This means that the government will buy or sell its currency in the market to maintain the agreed-upon exchange rate.
Step 2: Defining Flexible (Floating) Exchange Rates:
A flexible exchange rate, also known as a floating exchange rate, is determined by the market forces of supply and demand. In this system, the value of a currency fluctuates freely based on economic factors like inflation, trade balances, and interest rates. There is no intervention by the government to stabilize the currency value.
Step 3: Key Differences Between Fixed and Flexible Exchange Rates:
- Fixed exchange rate: The currency’s value is pegged to another currency or a basket of currencies. The government or central bank intervenes to maintain this fixed rate.
- Flexible exchange rate: The currency’s value is determined purely by market forces. The exchange rate fluctuates freely depending on demand and supply in the foreign exchange market.
Step 4: Final Conclusion:
The primary difference is that fixed exchange rates are managed by governments or central banks to maintain stability, whereas flexible exchange rates are determined by market dynamics without government intervention.