An exchange can operate under one of four main types of exchange rate systems:
Fully fixed exchange rates
In a fixed exchange rate system, the government (or the central bank acting on its behalf) intervenes in the currency market in order to keep the exchange rate close to a fixed target. It is committed to a single fixed exchange rate and does not allow major fluctuations from this central rate.
Semi-fixed exchange rates
Currency can move within a permitted range, but the exchange rate is the dominant target of economic policy-making. Interest rates are set to meet the target exchange rate.
The value of the currency is determined solely by supply and demand in the foreign exchange market. Consequently, trade flows and capital flows are the main factors affecting the exchange rate.
The definition of a floating exchange rate system is a monetary system in which exchange rates are allowed to move due to market forces without intervention by national governments. The Bank of England, for example, does not actively intervene in the currency markets to achieve a desired exchange rate level.
With floating exchange rates, changes in market supply and demand cause a currency to change in value. Pure free floating exchange rates are rare – most governments at one time or another seek to ‘manage’ the value of their currency through changes in interest rates and other means of controls.
Managed floating exchange rates
Most governments engage in managed floating systems, if not part of a fixed exchange rate system.
The advantages of fixed exchange rates
Fixed rates provide greater certainty for exporters and importers and, under normal circumstances, there is less speculative activity – though this depends on whether dealers in foreign exchange markets regard a given fixed exchange rate as appropriate and credible.
The advantages of floating exchange rates
Fluctuations in the exchange rate can provide an automatic adjustment for countries with a large balance of payments deficit. A second key advantage of floating exchange rates is that it allows the government/monetary authority flexibility in determining interest rates as they do not need to be used to influence the exchange rate.