Fixed Versus Floating Exchange rate Systems (DP IB Economics)

Revision Note

Reviewed by: Jenna Quinn

Many countries have attempted to use fixed exchange rate systems at some point in their history
Changes to the global or national equilibrium may cause Central Banks to consider which system may be most beneficial to achieving their macroeconomic goals at a specific point in time
- A fixed exchange rate system offers stability, reduces speculative activities, but limits monetary policy autonomy
- A floating exchange rate system allows for flexibility in monetary policy, automatic adjustments to economic conditions, but introduces greater exchange rate volatility
The choice between the two systems depends on a country's macroeconomic goals, stability objectives, and the external economic environment

A Comparison of a Fixed and Floating Exchange Rate System

Fixed Exchange Rate System	Floating Exchange Rate System
The central bank actively intervenes to maintain the fixed rate	The currency's value is determined by market forces of supply and demand
Provides stability and predictability for international trade and investment	Allows for greater flexibility in conducting independent monetary policy as interest rates and the money supply can be more easily manipulated
Limits a country's ability to independently conduct monetary policy as the focus is on exchange rate and not the interest rate	Allows for automatic adjustments to external shocks and changes in economic fundamentals Markets respond to changing fundamentals without the need for central bank intervention
Lowers speculative trading and currency volatility

Central Banks have to consider the impact of changing from one exchange rate system to another

Within a few minutes of removing the PEG, €1 = 0.90 CHF - the Swiss Franc had appreciated
(Source: FT.Com)

In January 2015 the Swiss Central Bank removed the fixed exchange rate (peg) of €1 = 1.2 CHF and allowed the currency to float freely
They did this because:
- In the face of ongoing significant demand for their own currency, the Central Bank was using enormous reserves to supply more CHF to the market in order to maintain the peg
- They could no longer afford to supply their own currency
- The demand for their currency was partly driven by deteriorating conditions in Russia as Russia had taken over the Crimea, which caused investors to seek safe haven for their money in Switzerland

The Implications of Changing from one System to Another - Real World Example

Impact	Explanation
Currency Appreciation	The Swiss Franc (CHF) experienced a significant increase in value against the Euro (EUR) as investors demanded it
Export Challenges	Swiss exporters faced difficulties as the stronger Swiss Franc made their products more expensive and less competitive in international markets
Impact on Tourism	The higher Swiss Franc made Switzerland a more expensive destination for foreign tourists, leading to a decrease in tourism revenue
Financial Market Turmoil	The sudden and unexpected appreciation of the Swiss Franc caused market turbulence and financial losses for investors holding Swiss Franc-denominated assets
Deflationary Pressure	The currency appreciation increased deflationary pressures in Switzerland, as imported goods became cheaper and domestic producers faced greater competition
Monetary Policy Challenges	The Swiss National Bank faced challenges in managing the exchange rate and preventing excessive appreciation while implementing independent monetary policy measures
Global Implications	The Swiss Franc's appreciation had repercussions beyond Switzerland, putting pressure on neighbouring countries and trading partners and affecting their exports and competitiveness

Last updated: 19 March 2024

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