Explain the two major exchange rate policies.

Question

What will be an ideal response?

Answer 1

There are two major exchange rate policies: floating rate and fixed rate. The floating (or flexible) exchange rate policy is the willingness of a government to let demand and supply conditions determine exchange rates. Governments adopting this policy tend to believe in the free market and allow it to determine exchange rates, usually on a daily basis via the foreign exchange market. However, few countries adopt a clean (or free) float, which would be a pure market solution. Most countries practice a dirty (or managed) float, with selective government interventions. The second major exchange rate policy is the fixed rate policy. A country adopting a fixed rate policy fixes the exchange rate of its domestic currency relative to other currencies. A specific version of fixed rate policy involves pegging the domestic currency, which means to set the exchange rate of the domestic currency in terms of another currency (the peg). Many developing countries, for example, peg their currencies to the US dollar. There are two benefits to a peg policy. First, a peg stabilizes the import and export prices. Second, many countries with high inflation have pegged their currencies to the dollar in order to restrain domestic inflation because the United States has relatively low inflation.