CIMA BA1 Syllabus A. Macroeconomic And Institutional Context Of Business - Government policies on exchange rates - Notes ^{5 / 5}

Free floating exchange rates

Free floating or flexible exchange rates occur when exchange rates are left to the interaction of market forces  (supply and demand for a currency).

A problem with allowing exchange rates to be determined by market forces is that if exchange rates change too much, the uncertainty surrounding fluctuations in exchange rates could deter trade and investment.

So, in practice, governments may prefer to intervene in the market to buy or sell currency in order to achieve a degree of exchange rate stability. 

This is sometimes called a managed (or dirty) floating exchange rate policy.

Fixed exchange rates

A government policy of buying and selling currency to fixed exchange rates by using its official currency reserves to create an exact match between supply and demand for its currency in the foreign exchange markets, in order to keep the exchange rate unchanged.

A fixed exchange rate system removes exchange rate uncertainty and so encourages international trade.