a) Fixed Exchange Rate

This is that rate at which the value of a currency remains stable vis-a-vis other currencies for a long period of time. These rates of exchange are fixed by the Central Bank through the process of pegging the currency concerned e.g. if the currency is pegged to a Dollar, then its value remains fixed to the value of the dollar and will move with movement in the value of the dollar.

 Advantages of Using Fixed Exchange Rates

i. It stabilizes the export proceeds and therefore it may stimulate exports for the period in which it is fixed.

ii. Foreign investors gauge the return on their investments in local currency vis-a-vis their own currencies. A fixed exchange rate will assure these investors of a stable return on their investment which may induce foreign investors, thus increasing the inflow of foreign exchange to the country.

iii. It enables the government to meet its development plans whose budgets are set in local currencies but may be financed by foreign loans and aid.

iv. It may keep inflation under control because the prices of imported goods will remain stable as long as the exchange rate is fixed. This is particularly true for imported inflation.

v. Long term investment plans can be worked out with substantial accuracy and may minimize budget deficits with their negative effects.

(b) Floating Exchange Rate

When the rate of exchange of a currency is floating, it is left to move in response to different forces (especially the balance of payments). It is left to be determined by the forces of demand and supply of foreign currencies of a given currency.

This rate may discourage investment by foreign investors as they are uncertain about the return to be earned on investment made under floating rates of exchange. It may also discourage export trade and may increase inflation rates.