Exchange rate is the rate at which currencies are traded. There are two types of currency exchange rate that are:
• Floating exchange rate
• Fixed exchange rate
Floating rate is a market driven price for currency which is determined by the free market forces of demand and supply with no government or central bank interference at all. The floating exchange system consists of the independent floating system and the managed floating system. The earlier is where exchange is sternly determined by the free movement of demand and supply. In some conditions it may be managed by the central bank to reduce day-to-day fluctuations and it is called managed floating system. Change Rate will depreciate if demand for the currency falls or if supply rises and appreciate if demand rises or supply falls.
For the fixed system government shows unwillingness to the country’s currency float freely, and they state a level at which the exchange rate will stay. The government takes whatever measures those are necessary to sustain the rate and avoid it from fluctuating. There are two methods at which price could be applied to the price of currencies that are fixed and pegged.
Under the umbrella of the fixed system, a decrease in the rate which is occasional is called revaluations. While an increase in the exchange rate is called devaluations. A devaluation in a fixed rate will cause the current account balance to rise, making a country’s export less expensive for foreign persons and also discourage the import by making import products more expensive for home consumers. This leads to an increase in trade surplus or a decrease in trade deficit. The reverse happens in a revaluation.
Floating system has following pros and cons
There is automatic correction in the floating system as the country simply lets it move liberally to the equilibrium of demand and supply.
• There is insulation from exterior economic events as the country’s currency is not tied to a possibly high world inflation rate as is under a fixed system.
• The free movement of demand and supply provides a shield to the home economy from world economic fluctuations
• Firms cannot forecast future rates, and it adds to uncertainty
• It leaves the international competitiveness of a country’s goods to a market that is often affected by speculative money flows;
Fixed system has following Pros & Cons
There is assurance in fixed system. With it, international trade and investment and becomes less risky.
There is slight or no speculation on a fixed system.
Fixed system contradicts the purpose of having free markets and it is not able to adjust to the shocks quickly like the floating system.