Determination of Exchange Rates
Expert reviewed • 21 July 2024 • 7 minute read
What are Fixed Exchange Rates?
In a fixed exchange rate system, a country's currency value is tied or pegged to another major currency, such as the U.S. dollar, the euro, or a basket of currencies. The government or central bank of the country intervenes in the foreign exchange market to maintain the currency's value within a narrow band or at a specific level relative to the anchor currency. This is done by the country's central bank, which actively buys and sells its own currency on the foreign exchange market to maintain the fixed rate.
Advantages of fixed exchange rates:
- Stability: Fixed rates provide a stable and predictable environment for international trade and investment, reducing currency risk.
Disadvantages of fixed exchange rates:
- Loss of monetary autonomy: Countries with fixed rates have limited ability to use monetary policy to address domestic economic challenges, as they must prioritise maintaining the fixed rate.
- Vulnerability to speculative attacks: Fixed rates can be vulnerable to speculative attacks if market participants believe the fixed rate is unsustainable. This can lead to a depletion of foreign exchange reserves.
What are Flexible Exchange Rates?
Under a flexible or floating exchange rate regime, the value of a currency is determined by the forces of supply and demand in the foreign exchange market. The central bank does not actively intervene to maintain a specific exchange rate. Rather, they allow the currency to appreciate or depreciate based on market conditions.
For example, the Australian dollar has operated under a flexible exchange rate regime since 1983, with its value determined by market forces. In 2020, the Australian dollar appreciated by 9.5% against the U.S. dollar, driven by factors such as stronger commodity prices and a faster economic recovery from the COVID-19 pandemic.
The Advantages of flexible exchange rates:
- Automatic adjustment: Flexible rates allow for automatic adjustment to changes in economic fundamentals, such as inflation, interest rates, and trade balances.
- Monetary autonomy: Countries with flexible rates have greater ability to use monetary policy to address domestic economic challenges, as they are not constrained by the need to maintain a fixed exchange rate.
The Disadvantages of flexible exchange rates:
- Volatility: Flexible rates can be more volatile, creating uncertainty for international trade and investment.
- Exposure to external shocks: Flexible rates can be more susceptible to external economic shocks, such as changes in commodity prices or shifts in global investor sentiment.
What are Managed Float Rates?
Under a managed exchange rate regime, also known as a dirty float, the value of a currency is largely determined by market forces, but the central bank may intervene occasionally to influence the exchange rate. This intervention can be aimed at smoothing excessive volatility or achieving specific policy objectives.
The Advantages of managed exchange rates:
- Flexibility with some control: Managed rates allow for some degree of market-determined flexibility while still providing the central bank with the ability to influence the exchange rate.
- Smoothing volatility: Central bank intervention can help smooth excessive exchange rate volatility, providing a more stable environment for international trade and investment.
The Disadvantages of managed exchange rates:
- Potential for misalignment: If the central bank's intervention is not consistent with economic fundamentals, it can lead to exchange rate misalignments and distortions in the economy.