Explain the difference between a fixed exchange rate and a floating exchange rate

1.      Demands of the Question

This is a 10 mark question that is to be written in 20 minutes. This question does not require me to evaluate anything. To answer this question, I need to define the terms, draw diagrams and compare the different exchange rate systems.

2.      Definitions

Fixed exchange rate: An exchange rate regime where the value of a currency is fixed, or pegged, to the value of another currency, or to the average value of a selection of currencies, or to the value of some other commodity such as gold

Floating exchange rate: An exchange rate regime where the value of a currency is allowed to be determined solely by the demand for, and the supply of, the currency on the foreign exchange market

3.      Cut and paste from Triple A

A fixed exchange rate system is one where the value of the exchange rate is fixed to another currency. This means that the government have to intervene in the foreign exchange market to maintain the fixed rate. The equilibrium exchange rate may be either above or below the fixed rate. In Figure 1 below, the equilibrium is above the fixed rate. There is a shortage of the national currency at the fixed rate. This would normally force the equilibrium exchange rate upwards, but the rate is fixed and so cannot be allowed to move. To keep the exchange rate at the fixed rate the government will need to intervene. They will need to sell their own currency from their foreign exchange reserves and buy overseas currencies instead. This has the effect of shifting the supply curve to S2 and as a result, their foreign currency holdings will rise.

Where the exchange rate is floating (as are all major currencies in the world), it will be determined by market forces – that is supply and demand. As in any other market, the rate will change constantly to reflect how much of the currency is being traded. However, what determines the supply and demand for the currency? Let’s take the Baht (the Thai currency) as an example and look at the factors that affect supply and demand and therefore the equilibrium exchange rate.

4.      Bullet points of this

  • Government intervenes in the foreign exchange market to maintain the fixed rate
  • Equilibrium exchange rate may be either above or below the fixed rate
  • Shortage of the national currency at fixed rate
  • Government will need to sell their own currency from their foreign exchange reserves and buy overseas currencies instead
  • The rate will change to reflect how much of the currency is being traded

5.      Insert relevant PP slides

6. Diagrams

7. Evaluation Suggestions

NO EVALUATION!

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