What do you really mean by fixed and floating exchange?

Question

What do you really mean by fixed and floating exchange?

Answer 1

If a country has a fixed exchange rate, this means that the central bank of that country is willing to buy or sell any amount of its currency against another reference currency at a fixed price. Anyone selling below that price or buying above that price on the currency market loses money, therefore the price remains at the fixed level. The reference currency can be another currency or a basket (weighted average) of several currencies.

If a country has a floating rate, this means that the price of the currency will be determined by offer and demand on the currency market. This price is then driven by factors such as the level of interest rates paid on individual currencies or future investment profitability prospects in a currency area (="fundamentals").

Changing fundamentals in a fixed currency rate regime might lead the central bank of that country to be forced to sell or buy huge amounts of its currency. If this leads to depletion of foreign exchange reserves of that bank or to intolerable levels of inflation, the fixed exchange will brake down. Practically, if currency markets believe that the fixed rate is at the wrong level, this can lead to speculation against that central bank and in turn accelerate the breakdown.

A breakdown means that the central bank either must change the fixed exchange rate level (depreciate or appreciate the currency) or revert to a floating exchange regime.