Differentiate between fixed and flexible exchange rate

               Fixed and Flexible Exchange Rate

Fixed Exchange Rate:

An exchange rate is defined as the value of one countries currency in terms of the other country’s currency. For example the exchange rate of Rupee in terms of dollar is around D 65  per US $. This is the nominal exchange which keeps on changing from time to time depending upon market conditions of two economies. The exchange rates may be either fixed or it may be flexible.

An exchange rate is said to be fixed whenever its value is fixed by the concerned authorities and the central bank of the economy stands ready to buy and sell its currency in the market at a fixed price in order to maintain the fixed exchange rate of its currency with respect to another currency. The Central Bank has to maintain excess reserves and be always ready to buy and sell the foreign currency as per the market conditions.

Whenever there is excess demand of foreign currency in the economy, the Central Bank can sell the foreign currency and purchase the domestic currency keeping the exchange rate constant.

Similarly, in case of excess supply of foreign currency, the Central Bank can buy this foreign currency and sell the domestic currency in the market, thereby again maintaining the exchange rate at a fixed level.

However, without the excess reserves, the Central bank can not intervene in the market and hence cannot maintain the exchange rate at a constant price.

Flexible or Floating Exchange Rate:

An exchange rate is said to be flexible or floating whenever its value is determined by the market forces of demand and supply. Here, the central bank has to allow exchange rate to float or adjust to the market conditions prevailing in the economy. The central bank of a particular country does not have to intervene in the market to maintain the exchange rate at fixed level. The market forces determine the exchange rate.

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