Fixed vs Floating Exchange Rates
CIE A-Level EconomicsΒ· Unit 8: International Finance and GlobalisationΒ· 35 min read
1. Core Definitions and Key Featuresβ β ββββ± 10 min
An exchange rate regime is the framework a government uses to set the value of its currency relative to other currencies. The two broad categories are fixed and floating exchange rates, with most economies falling somewhere in between.
Fixed Exchange Rate Regime
A system where the central bank pegs the value of domestic currency to a reference currency (usually the US dollar) or gold, and actively maintains this fixed value via intervention.
Example:
Hong Kong pegs the Hong Kong Dollar to the US Dollar at 7.8 HKD = 1 USD.
Floating Exchange Rate Regime
A system where the value of domestic currency is determined entirely by free market forces of supply and demand, with no target value set by policymakers.
Example:
The Japanese Yen operates under a pure floating regime.
A country pegs its currency at $1 = 15 pesos. Market demand for pesos has increased, so the equilibrium market rate would be $1 = 12 pesos. What action must the central bank take to maintain the peg?
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Step 1: Identify the disequilibrium: at the current peg, the peso is undervalued, so there is excess demand for pesos.
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Step 2: To prevent the peso from appreciating and maintain the fixed peg, the central bank must increase the supply of pesos.
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Step 3: It does this by selling pesos (domestic currency) and buying foreign currency (US dollars), adding to its foreign exchange reserves.
2. Adjustment to External Shocksβ β β βββ± 15 min
The most impactful difference between the two regimes is how they adjust to external shocks such as a fall in export demand or a rise in global oil prices. Under floating rates, adjustment happens automatically via exchange rate changes. Under fixed rates, policymakers must actively intervene, often with negative domestic consequences.
For a current account deficit: under floating rates, excess demand for foreign currency causes domestic currency depreciation, which makes exports cheaper and imports more expensive, automatically correcting the deficit. Under fixed rates, the central bank must use foreign reserves to buy domestic currency, or deflate the domestic economy to reduce import demand.
A small open agricultural exporter faces a sudden fall in global export demand. Compare adjustment under fixed and floating exchange rates.
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Step 1: Under floating rates: lower export demand reduces demand for domestic currency, leading to depreciation.
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Step 2: Higher net exports offset the fall in aggregate demand, limiting the impact on domestic output and employment.
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Step 3: Under fixed rates: no depreciation is allowed, so excess supply of domestic currency develops. The central bank must use foreign reserves to buy domestic currency.
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Step 4: If reserves run out, the central bank must raise interest rates to attract foreign capital, which reduces domestic consumption and investment, leading to lower output and higher unemployment.
3. Evaluation: Advantages and Disadvantagesβ β β βββ± 15 min
CIE exam questions regularly ask candidates to evaluate which regime is preferable for a given economy. The optimal choice depends on the economy's specific characteristics: size, trade openness, inflation history, and policy credibility.
The key pros and cons of each regime are summarised below:
Fixed Exchange Rates
Regime targeting a fixed currency value
+ Pros: Reduces exchange rate uncertainty for trade and investment; Acts as a nominal anchor to control high inflation
β Cons: Requires large foreign reserve holdings; Loss of independent monetary policy; Risk of speculative currency crises if the peg is unsustainable
Floating Exchange Rates
Regime where value is set by the market
+ Pros: Automatic adjustment to external shocks; Full independent monetary policy for domestic goals; No need for large foreign reserve holdings
β Cons: Short-term volatility discourages trade and investment; Allows excessive speculation and currency misalignment; No nominal anchor for inflation, enabling loose monetary policy
A country has a 20-year history of high inflation and low central bank credibility. It is choosing between a fixed and floating exchange rate. Which regime is preferable?
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Step 1: The country's core problem is lack of monetary policy credibility, which keeps inflation expectations and long-term inflation high.
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Step 2: A fixed exchange rate acts as a credible nominal anchor, because the central bank cannot print money to finance spending without breaking the peg.
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Step 3: This will lower inflation expectations and bring down long-term inflation, which is the country's key priority.
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Step 4: Therefore, a fixed exchange rate is preferable here, despite the loss of monetary policy autonomy.
Exam tip:
Always link your evaluation to the specific context of the economy in the question. Small, open, trade-heavy economies gain more from fixed rates than large, closed economies.
4. Managed Float: The Intermediate Regimeβ β β β ββ± 10 min
Almost all economies today operate an intermediate regime between pure fixed and pure floating, called a managed float (or dirty float).
Managed Float
A hybrid regime where the exchange rate is mostly determined by market forces, but the central bank intervenes occasionally to smooth excessive short-term volatility or correct extreme misalignment, without committing to a fixed target rate.
The British pound depreciates 10% in one week due to speculative market pressure. How does the Bank of England (which operates a managed float) typically respond?
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Step 1: The central bank does not commit to any specific target exchange rate, but will intervene to limit excessive, disorderly volatility.
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Step 2: It can sell foreign currency reserves and buy pounds to increase demand for the currency, slowing the rate of depreciation.
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Step 3: It may also temporarily raise interest rates to attract foreign capital, further supporting the currency.
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Step 4: Unlike a fixed regime, intervention is temporary and discretionary, not a permanent commitment to a specific exchange rate level.
5. Common Pitfalls
Wrong move:
Confusing devaluation (fixed rates) with depreciation (floating rates)
Why:
CIE examiners explicitly penalise mixing up these terms, as they describe fundamentally different processes
Correct move:
Use devaluation for a deliberate central bank cut to a fixed peg, and depreciation for a market-driven fall in a floating rate
Wrong move:
Claiming fixed exchange rates eliminate all exchange rate risk
Why:
Unsustainable fixed pegs are often adjusted or abandoned, leading to large sudden currency moves that create major risk
Correct move:
Fixed rates reduce short-term volatility but carry the risk of large sudden adjustments and full currency crises
Wrong move:
Assuming floating rates always automatically correct current account deficits
Why:
Demand elasticities for exports and imports are often low in the short run, and speculation can move rates far from equilibrium
Correct move:
While floating rates enable automatic adjustment, the speed and effectiveness depend on trade elasticities and market stability
Wrong move:
Claiming central banks never intervene in floating exchange rate regimes
Why:
Most 'floating' currencies are actually managed floats, with occasional intervention, pure floats are extremely rare
Correct move:
Pure floating regimes have no target exchange rate and almost no intervention; most major currencies operate a managed float
6. Quick Reference Cheatsheet
Feature | Fixed Exchange Rate | Floating Exchange Rate |
|---|---|---|
Value determined by | Central bank peg | Market supply and demand |
Current account deficit adjustment | Reserve sales / domestic deflation | Automatic currency depreciation |
Monetary policy autonomy | Lost (tied to the peg) | Full autonomy for domestic goals |
Foreign reserve requirement | High (large reserves needed) | Low (minimal reserves needed) |
Key advantage | Stability for trade/investment | Automatic adjustment to external shocks |
Key disadvantage | High risk of currency crises | Short-term exchange rate volatility |
7. Frequently Asked
What is the difference between devaluation and depreciation?
Devaluation is a deliberate downward adjustment of a fixed exchange rate by a central bank. Depreciation is a fall in the value of a floating exchange rate caused purely by market forces of supply and demand.
Do most countries use pure fixed or pure floating rates?
Very few countries use pure regimes. Most operate a managed float, an intermediate system where rates are mostly market-determined, with occasional central bank intervention to smooth volatility.
When this came up on past exams
AI-estimated based on syllabus patterns β cross-check with official past papers for accuracy. Use only as revision-focus signals.
- 2022 Β· 2
Compare fixed vs floating exchange rates
- 2021 Β· 4
Evaluate fixed exchange rate regime
- 2023 Β· 2
Adjustment to current account deficit
Going deeper
What's Next
Understanding how exchange rate regimes work is a core foundation for analysing further topics in international economics, including currency crises, the impact of exchange rate changes on the current account, and the costs and benefits of common currency areas like the Euro. The evaluation skills you built here comparing trade-offs between different policy regimes will be critical for high-mark essay questions in both Paper 2 and Paper 4 of the CIE 9708 exam, where you will often be asked to assess whether a country should change its exchange rate regime or join a currency union.