Fixed vs Flexible Exchange Rate – A Primer

We look at the raging questions on the fixed vs flexible exchange rate conundrum. The trilemma vs dilemma debate and the impact on monetary policy independence with the choice of exchange rate mechanism is also explored.

Exchange rate understandings are of little use on their own.

Charles Dallara

Whenever we see news of exchange rate of domestic currency appreciating or depreciating in the foreign exchange market some questions come to mind. The topic of fixed vs flexible exchange rate is not only of interest to academicians but also to practitioners. We try to answer some of these questions through a short video. The video discusses several important points. It starts with what is exchange rate and the differences between fixed and flexible exchange rate. Further, we discuss the reasons for dominance of flexible exchange rate and benefits of different exchange rate mechanisms. Finally, the constraints of the trilemma and the impact on monetary policy independence are brought out.

We build some flowchart examples capturing the impact of central bank actions on capital flows, exchange rate, inflation and output. We also show that money supply and interest rates can move from external influences. The examples show that flexible exchange rate is very important to protect domestic economy from foreign disturbances. This mechanism also gives the benefit of according monetary policy independence. Although, as global financial cycles become dominant, capital controls or macro-prudential norms may become necessary. Then only monetary policy will remain independent even under a flexible exchange rate.

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