Fixed vs Floating Interest Rate

2178 Words Sep 9th, 2011 9 Pages
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Fixed versus floating exchange rates

Introduction

The exchange rate regime
The exchange rate regime is the way a country manages its currency in respect to foreign currencies and the foreign exchange market. Each country has its exchange rate policy which determines the form of a government influence on the currency exchange rate.

There are three main type of the exchange rate regime: • a floating exchange rate, where the market dictates the movements of the exchange rate, • and the fixed exchange rate, which ties the currency to another currency, • a pegged float, where the central bank keeps the rate from deviating too far from a target band or value, divides into 2 subtypes: o Crawling bands:
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Inability to shock adjustments
When the fixed exchange rate is used there is no automatic mechanism of economy adjustments in case of crisis. Then the government have to use its reserves in order to protect its currency. If the crisis is profound the reserves can be insufficient to support the currency and maintain the balance. It can lead to depression or deflation. In some cases devaluation of the currency would be necessary.

Speculation probability
When there is a problem with balance of payments the speculator can expect the necessity of exchange rate adjustment. In case of growing deficit they can worsen the situation by selling the currency and thus even enlarge the deficit.

The floating exchange rate
A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency 's value is allowed to fluctuate according to the foreign exchange market. The exchange rate is determined by the relationship between demand and supply. The phenomenon of lowering a floating exchange rate the currency is defined as depreciation and the growth rate as an appreciation. A currency that uses a floating exchange rate is known as a floating currency. Floating exchange rates automatically adjust what can dampen the impact of shocks and foreign business cycles.

Advantages of a free-floating exchange rates

Automatic correction
The exchange rate is free to change until it reaches equilibrium and thus automatically adjusts the balance
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