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Fixed vs Floating Exchange Rate Systems: Comparison and Evaluation
IB DP Economics — Unit 4: The Global Economy | HL | 4.5 Exchange Rates [HL Extensions]
📋 What You Will Learn
- Define fixed and floating exchange rate systems and identify their key characteristics
- Explain how a fixed exchange rate is maintained through central bank intervention
- Analyse the advantages and disadvantages of each exchange rate system
- Apply exchange rate theory to evaluate the suitability of each system for different economies
- Evaluate the conditions under which a fixed or floating system is more appropriate, using real-world evidence
- Distinguish between managed float and currency board arrangements as intermediate systems
🔍 Guiding Question Under what economic conditions is a fixed exchange rate system preferable to a floating one — and who ultimately bears the cost when a fixed rate becomes unsustainable?
🌍 Why This Matters In 2023, Egypt's central bank was forced to devalue the Egyptian pound by over 50% after years of defending a fixed rate — burning through foreign reserves and triggering a severe inflation crisis. Meanwhile, the UK's floating pound absorbed the shock of post-Brexit trade disruption through gradual depreciation, avoiding a reserve crisis entirely. Same global pressures; radically different outcomes — because the exchange rate system shapes how an economy absorbs shocks.
1. What Is an Exchange Rate System?
Every country's currency must have some relationship with other currencies. The exchange rate system determines whether that relationship is determined by market forces, fixed by government policy, or managed somewhere in between. The choice has profound implications for monetary policy autonomy, trade competitiveness, and macroeconomic stability.
📖 Definition — Exchange Rate System An exchange rate system is the set of rules and institutional arrangements that determine how a country's currency is valued relative to other currencies and how that value is managed or allowed to change over time.
There are three broad categories: floating (market-determined), fixed (pegged), and managed float (a hybrid). Each involves a different trade-off between exchange rate stability and monetary policy independence.
2. Floating Exchange Rate Systems
📖 Definition — Floating Exchange Rate A floating exchange rate is one determined entirely by the forces of supply and demand in the foreign exchange (forex) market, with no government or central bank intervention to target a specific rate.
How the Floating Rate Is Determined
- The exchange rate is the price of one currency in terms of another — determined in the forex market
- Demand for a currency comes from: foreigners buying exports, inward foreign direct investment (FDI), speculation, and tourism inflows
- Supply of a currency comes from: residents buying imports, outward investment, speculation, and tourism outflows
- If demand for a currency rises (e.g. exports increase), the currency appreciates — its value rises
- If supply of a currency rises (e.g. imports increase), the currency depreciates — its value falls
- No foreign exchange reserves are needed to maintain the rate — the market clears automatically
📖 Definition — Appreciation and Depreciation Appreciation is an increase in the value of a currency under a floating system, caused by excess demand in the forex market. Depreciation is a decrease in the value of a currency under a floating system, caused by excess supply. Both occur automatically without government intervention.
Causes of Currency Depreciation (Floating System)
- Increase in imports → increased supply of domestic currency on forex markets
- Capital outflows (e.g. residents investing abroad) → increased supply of domestic currency
- Falling interest rates → reduced demand from foreign investors seeking yield
- Inflation higher than trading partners → exports become less competitive → reduced demand for currency
- Speculation that the currency will fall → self-fulfilling selling pressure
3. Fixed Exchange Rate Systems
📖 Definition — Fixed Exchange Rate A fixed exchange rate (also called a pegged exchange rate) is one in which the government or central bank commits to maintaining