Fixed vs Floating Exchange Rates (HL)

Although both have their own benefits, they are usually opposite to each other (fixed benefits = floating drawbacks, etc.)

• Stability: 

  • • Fixed: Fixed rates are more predictable, hence the exchange rate less risky, encouraging investment. 

    • Floating: Floating rates are more risky.

• Investors try and play the game: 

  • • Fixed: Since fixed rates will require the central bank buying up excess supply, speculators may try weird strategies (sell all their reserves at once) to try and break the fixed rate for profits. This is costly for the central bank. 

    • Floating: This can not happen with floating rates as the government is not intervening.

• Opportunity cost: 

  • • Fixed: The central bank needs massive reserves of both domestic and foreign currency in order to uphold a fixed rate. 

    • Floating: Floating rates don't require this.

• Availability of money (liquidity): 

  • • Fixed: When the central bank holds loads of currency in case it needs to sell, there is less left for other investors. This may increase volatility, as any buy/sale will have a larger impact on equilibrium.

    • Floating: Since the central bank is letting the market mechanism work, it does not need reserves and hence markets are more liquid.