A floating exchange rate refers to an exchange rate regime, which allows the local currency of a country to fluctuate with respect to the foreign exchange market. Any form of currency that adopts this form of exchanged rate is called a floating currency. For other countries that do not use this form of exchange rate regime, they adopt the fixed exchange rate. This form of exchange rate refers to the maintenance of a currency value in a fixed rate against other currencies. Out of the two forms exchange rate systems, it is possible to develop a hybrid exchange rate. Some examples of the hybrid exchange rate systems are the linked exchange rate and managed floating regimes. Based on the above exchange rate regimes, a country in a dilemma regarding the exchange rate regime to adopt should critically evaluate the choice that meets its needs. Nevertheless, a country should base the convenient exchange rate of choice on its economic growth level and the target level of economic development (Barth, 1994).
The adoption of a fixed exchange rate would necessitate a country to announce a fixed rate to which it is going to exchange its domestic currency against the foreign currency. This implies that the buying and selling value will be predetermined and consistently maintain. In this regard, the maintenance of market equilibrium would necessitate the country to make reserves of foreign currency or gold to correct any form of disequilibrium caused by excess demand or supply. The gold standard defines the weight of gold that a country admits to exchange with a certain amount of its currency. Meanwhile, the reserved foreign currency plays the role of the gold. As a result, this form of exchange regime would make a country benefit from the stabilization of its economic activities.
Since fixed exchange rates provide a stable economic environment in a country, many benefits will accrue. Initially, the country’s central bank credibility would increase thus increasing the number of investors. Since the exchange rate is fixed, it is going to eliminate the level of exchange rate risk, which fosters a reduction of speculation. For exchange rate to fit this pledged policy, the monetary authority should impose discipline and stern regulations. In situations where the country is not well established, the adoption of this form of exchange of regime would imply large reserves of foreign currency would be set aside to facilitate the correction of any disequilibrium in the market (Klein, 2010). Similarly, if the country maintains the gold standards, it implies that there would be limitations in the tradable value of gold. Therefore, the need for comparative advantage would reduce since specialization is restricted as per the fixed terms of international trade.
Contrary to the fixed exchange rate, a country could adopt the floating exchange rate, which allows the fluctuation of the local currency to the foreign currencies. Despite the market’s exposure to the volatility of the foreign exchange markets, there exist multiple benefits. This regime adequately addresses the crucial element of the maintenance of market equilibrium. Since the market fluctuates with respect to foreign markets, the forces of demand and supply would set the equilibrium automatically (Visser, 2000). In comparison to the fixed exchange rate system, the government is relieved the need to set up reserves or maintain certain gold standards. This implies that the government could use the amounts intended for reserves to foster investment in the country. While considering the exchange rate fluctuations, it is essential to keep in mind the emergence of hedging concept. These skills would allow firms participating in the international trade to exploit the practice and reduce their vulnerability to the exchange rate risks.
Nevertheless, the fact that there is the exposure of the currency market to currency fluctuations implies that during economic recessions the country is bound to suffer from its adversity.
As a country evaluates the appropriate exchange rate system to adopt, it is essential to take into consideration the need for hybrid exchange systems. These systems exhibit a mixture of both features of the fixed and floating exchange rate regimes. One of the most appropriate systems could be the managed floating exchange rate system. This form of exchange rate system exhibits multiple features of the floating exchange rate, but with some aspects of fixed exchange rate (Williamson, 2000). With this type of regime, the currency market can to fit its own equilibrium automatically. To counter the risks of adversity in foreign currency market, the country sets up ceiling and floors of its currency against the foreign currency. This implies that the currency market can fluctuate within the bounds freely. In the event that the currency market exceeds the bounds, the government has to take radical measures to streamline the economic condition through the set reserves or gold standards approaches. Since this form of currency exchange rate system is more flexible concerning the parent exchange rate regime, its benefits outweigh those of others.
As a result, for a country with the need to adopt a flexible exchange rate system, a managed floating exchange would be the most convenient. This form of exchange rate would allow the government’s currency to freely trade with its counterparts, but on set limits. This would minimize the exposure of investors within the country to any severe economic conditions. Similarly, on normal trading periods, the investors engaged in international trade would utilize hedging as the counter-measure for exchange rate risks. Additionally, the country would utilize its comparative advantage to exploit the opportunities of international trade. This implies that among all the forms of exchange rate systems, the managed floating exchange rate system would be the most appropriate.