Difference between Fixed, Floating and Flexible Exchange Rate are described below:
There are many variables, which affect the rate of exchange of two currencies of two countries. Government has a big role to play in deciding the rate of exchange.
According to the role of Government, rate of exchange determination can be divided into three categories, viz., fixed exchange rate, Floating exchange rate and free exchange rate.
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(i) Fixed Exchange Rate:
Under fixed rate regime, Government fixes the rate of exchange at which foreign currencies can be bought and sold. Exchange rate is fixed with respect to value of gold per ounce or with respect to dollar or pounds. Once exchange rate is fixed, supply and demand of foreign exchange is regulated by central bank of the country.
Exporters have to deposit their foreign currencies with the central bank and importers have to request the central bank to release foreign exchange. Fixed exchange rate regime removes uncertainty in conducting foreign trade and avoids the competitive depreciation of their respective currencies, which may lead to the danger of global recession.
Although foreign exchange rate regime reduces uncertainty in conducting foreign trade, but domestic adjustment becomes very painful and politically sensitive. Sometimes, such adjustment may lead to war between nations.
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One of the reasons of Second World War was the fixed exchange rate regime of that time and great depression of 1939, which helped Adolf Hitler to capture power in Germany.
The adjustment mechanism in case of fixed exchange rate regime is as follows- If a country has deficit in its balance of payment, foreign currency or gold will flow out of the country. This will reduce ‘Money Supply’, which will lead to reduction in price level.
Reduction in price level will decrease the prices of exported items and increase export revenue. Reduction in price level will also increase the relative prices of imported items and reduce import expenditure. Increase in export revenue and decrease in import expenditure will improve balance of payment position of the country.
The danger of decrease in price level due to deficit in Balance of Payment is that business community may become pessimistic and postpone their investment. This may lead to depression in the economy.
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Similarly if a country has surplus in its balance of payment, foreign currency or gold will flow into the country. This will increase ‘Money Supply’ which will lead to increase in price level.
Increase in price level will increase the prices of exported items and decrease export revenue. Increase in price level will also decrease the relative prices of imported items and increase import expenditure. Decrease in export revenue and increase in Government expenditure will lead to decrease in the surplus of the Balance of Payment.
The danger of surplus in the Balance of Payment is that increase in price level may go out of control of the Government leading to hyper inflation and redistribution of national income. This adversely affects those earning fixed income and lead to political instability.
(ii) Floating Exchange Rate:
Under this system, Government fixes the range of foreign exchange rate within which foreign exchange is allowed to fluctuate according to the demand and supply of foreign currency in the market.
For example, if rate of exchange of Rupee and Dollar is Rs. 50=1 $ and Government decides to allow 10% margin, then till the rate does not exceed Rs. 55 or fall below Rs. 45, central bank is not allowed to intervene in the foreign exchange market. Rate of exchange is allowed to fluctuate between Rs. 55 to Rs. 45 per dollar.
If the rate moves above Rs. 55, central bank will intervene by supplying dollars in the market till exchange rate falls below Rs. 55. If the rate falls below Rs. 45, then central bank will buy dollar from the market till exchange rate rises above Rs. 45.
This type of exchange rate mechanism is very useful as it provides the benefit of fixed exchange rate and flexible exchange rate.
(iii) Flexible Exchange Rate:
Under this system, exchange rate is determined by market forces. Demand and supply of foreign exchange by importers and exporters respectively determine the rate of exchange. Demand of foreign exchange curve is downward sloping because lower the value of dollar, more dollars will be demanded for importing goods.
Supply of foreign exchange curve is upward sloping because higher the value of dollar, more goods will be exported and more dollars will be earned by the exporter. Rate of foreign currency is determined by the interaction of demand and supply curve of foreign exchange.
Excess of demand for foreign currency will push up its prices till both demand and supply becomes equal. Excess of supply for foreign currency will lead to fall in the prices till both demand and supply become equal.