Differentiate fixed exchange rate and floating exchange rate
Fixed exchange rate:
1. In a fixed exchange rate system, the value of a country's currency is fixed or pegged to another currency, a basket of currencies, or a specific value such as gold.
2. The government or central bank is responsible for maintaining the fixed exchange rate by buying or selling its currency on the foreign exchange market.
3. Fixed exchange rates provide stability and predictability for businesses and investors as they know the exact value of the currency.
4. However, fixed exchange rates can lead to currency crises if the pegged value becomes unsustainable or if the government's foreign reserves are depleted.
Floating exchange rate:
1. In a floating exchange rate system, the value of a country's currency is determined by supply and demand in the foreign exchange market.
2. The exchange rate fluctuates based on various factors such as economic indicators, market sentiment, geopolitical events, and government policies.
3. Floating exchange rates allow for adjustments in response to changing economic conditions, which can help maintain a balance of trade and reduce the risk of currency crises.
4. However, floating exchange rates can be more volatile and unpredictable compared to fixed exchange rates, which can create uncertainty for businesses and investors.