Fixed vs Floating Exchange Rates

Introduction:
This essay will discuss the two forms of exchange rate regimes for a country, namely: a fixed exchange rate and a flexible exchange rate. I will discuss some advantages and disadvantages of these regimes and will comment on their effectiveness in small economies. Although every country differs and there is therefore not only one correct regime for all small economies, there are some factors that should be considered in all economies when deciding on a regime.

More about exchange rate policies:
An exchange rate is one countries currency in terms of another. Broadly, there are two categories of exchange rates, fixed and flexible exchange rates. In both the degree varies. With fixed exchange rates, a country fixes or pegs their currency to another currency, usually that of a stronger economy.   The central bank sets and has to maintain this official exchange rate by buying and selling its own currency on the foreign exchange market.   With a flexible interest rate regime the interest rate is determined by the forces of supply and demand.   The differences that exists between supply and demand in the market is corrected in the market itself. It is important to note however that no currency is completely fixed or floating. In some cases market powers can influence a fixed exchange rate and in other cases government may intervene to achieve a desired flexible exchange rate.

Fixed and floating regimes in small economies:
Some of the factors that the selection of a regime for a country depend in are: the size of a country, the stage of financial development, the import and export structure, current and past inflation in the country, the type of external and internal shocks it may face, the political climate and the credibility of the financial institutions and policy makers. The correct choice of regime might also change over time. A country has to decide which of these factors it sees as most important.