The paper 'What Fixed and Floating Exchange Rates Are' is a great example of a Finance and Accounting Case Study. An exchange rate refers to the amount of one currency that would have to be paid to receive one unit of another currency. International transactions involving the exchange of goods, assets, or services require the exchange of currencies since those who sell generally want to receive payment in their own currency. This exchange of currencies is determined by the exchange rate regime adopted by a particular country. There are two common types of exchange rate regimes: fixed exchange rate and floating exchange rate.
This paper will explain the two types of exchange rates and evaluate their costs and benefits. Based on the analysis, the paper will indicate the exchange rate regime that is preferred by international businesses. Definitions of fixed and floating exchange rates A fixed exchange rate regime is one in which the value of one country’ s currency is tied or pegged (sometimes loosely) to the value of some other currency (Daly & Farley 2010, p. 391; Vargas-Silva 2010, p.
431). This means that in such an exchange rate regime, the price of one currency is fixed vis-à -vis all other currencies by government authorities (Megginson & Smart 2008, p. 729). Under the fixed exchange rate system, governments peg or fix their currency’ s value, usually in reference to another currency such as the US dollar. For instance, between 1994 and 2004, the Chinese renminbi was fixed to the dollar at a ratio of about 8.3:1; implying that the People’ s Bank of China would sell any number of dollars that anyone wanted for at a rate of 8.3 renminbi per dollar (Daly & Farley 2010, p.
391). It is evident from this example that the central bank needed to have foreign currency at hand to facilitate this exchange. This currency would be derived from the demand for Chinese products. On the other hand, a floating exchange rate is a system whereby the exchange rate is determined by international supply and demand for currencies, or in other words, market forces (Daly & Farley 2010, p. 392; Megginson & Smart 2008, p. 729). In this case, as opposed to the fixed exchange rate system where central banks peg the value of one currency to another, the central bank plays no direct role in determining how the rate of exchange of currencies changes.
In the floating exchange rate regime, currencies are left to float freely and their values are established by demand and supply in the foreign exchange market (Vargas-Silva 2010, p. 432). In this case, the only currency which is available for buying goods, assets, or services is that which foreigners use on the purchase of domestic goods, assets, and services.
If the demand for foreign currency is higher than the supply, its price will increase, implying that the national currency depreciates. On the flip side, when the demand for foreign currency is lower than the supply of the same, the national currency appreciates (Daly & Farley 2010, p. 392). As noted, the demand for and supply of the foreign currency determine the exchange rate under a fixed exchange rate system.
Arnold, R A 2008, Microeconomics, 9th edn, Cengage Learning, New York.
Butler, K 2012, Multinational finance: Evaluating opportunities, costs, and risks of operations, 5th edn, John Wiley & Sons, New York.
Daly, H E & Farley, J 2010, Ecological economics, second edition: Principles and applications, 2nd edn, Island Press, Washington DC.
Frankel, J A 1997 ‘Monetary regime choice for a semi-open country’, In Edwards, S (ed), Capital controls, exchange rates, and monetary policy in the world economy, Cambridge University Press, Cambridge. Chapter v, pp. 35-70.
Glanville, A & Glanville J 2011, Economics from a global perspective, 3rd edn, Glanville Books, London.
Grant, S & Vidler, C 2000, Economics in context, Heinemann, London.
Hall, M G 2005, Exchange rate crises in developing countries: The political role of the banking sector, Ashgate Publishing, Ltd., London.
Kanyenze, G & Kondo, T 2011, Beyond the enclave: Towards a pro-poor and inclusive development strategy for Zimbabwe, African Books Collective, Oxford.
Megginson, W L & Smart, S B 2008, Introduction to corporate finance, 2nd edn, Cengage Learning, New York.
Vargas-Silva, C 2010, ‘Exchange rates’, In Free, R C, 21st Century economics: A reference handbook, volume 1, Sage, London. Chapter 42, pp. 431- 439.