Flexible Exchange Rates

Definition

Flexible exchange rates, also known as floating exchange rates, are a system where the value of a country's currency is determined by the foreign exchange market based on the supply and demand for that currency. This contrasts with fixed exchange rates, where the value is pegged to another currency or a basket of currencies.

5 Must Know Facts For Your Next Test

1. Flexible exchange rates allow a currency's value to fluctuate freely based on market forces, rather than being artificially pegged by the government.
2. The flexible exchange rate system was adopted by many countries in the 1970s after the collapse of the Bretton Woods fixed exchange rate system.
3. Flexible exchange rates can help a country adjust to external shocks and imbalances in trade by allowing the currency to depreciate or appreciate accordingly.
4. Fluctuations in flexible exchange rates can impact a country's trade balance, as changes in the currency value affect the relative prices of exports and imports.
5. Governments may still intervene in flexible exchange rate systems to smooth out excessive volatility or to achieve certain economic policy objectives.

Review Questions

• Explain how flexible exchange rates work and how they differ from fixed exchange rates.
  • Flexible exchange rates are determined by the foreign exchange market based on supply and demand for a country's currency, rather than being artificially pegged by the government as in a fixed exchange rate system. This allows the currency's value to fluctuate freely, which can help a country adjust to external shocks and trade imbalances. In contrast, fixed exchange rates maintain the currency's value within a narrow band through government intervention, sacrificing some economic flexibility.
• Describe the relationship between flexible exchange rates and a country's trade balance.
  • Fluctuations in flexible exchange rates can have a significant impact on a country's trade balance. If a country's currency depreciates, its exports become more affordable for foreign buyers, potentially increasing exports and improving the trade balance. Conversely, a currency appreciation makes the country's exports more expensive, potentially reducing exports and worsening the trade balance. The flexible exchange rate system allows the currency to adjust and help correct trade imbalances.
• Evaluate the advantages and disadvantages of a flexible exchange rate system compared to a fixed exchange rate system in the context of a country's macroeconomic performance and policy objectives.
  • The main advantage of a flexible exchange rate system is its ability to help a country adjust to external shocks and imbalances in trade. The currency can depreciate to make exports more competitive or appreciate to control inflation, providing more policy flexibility. However, excessive exchange rate volatility can also introduce uncertainty and risk for businesses and consumers. Governments may still intervene in flexible systems to smooth out extreme fluctuations. Ultimately, the choice between flexible and fixed exchange rates depends on a country's specific economic circumstances and policy priorities, such as maintaining price stability, promoting exports, or managing capital flows.

Related terms

Fixed Exchange Rates: A system where the value of a country's currency is pegged to another currency or a basket of currencies, with the exchange rate maintained within a narrow band by government intervention.

Foreign Exchange Market: The global decentralized market where currencies are traded, determining their relative values in relation to one another.

Trade Balance: The difference between a country's imports and exports, reflecting its net position in international trade.