To know which exchange rate system is the best, the objectives of the monetary authorities in a country have to be studies.

There are three possible objectives:

  1. Maintain stable exchange rates
  2. Allow mobility of capital
  3. Have control over monetary

With a floating exchange rate, the last two objectives can be attained but there will be exchange rate volatility. With a fixed exchange rate, the first two objectives can be attained but there will be no control over the monetary policy. In other words, irrespective of whether the fixed rate or the floating exchange rate is selected, only two of the three objectives can be attained. Thus, the three objectives are called the impossible trinity. In practice, countries can and do fine-tune their exchange rate systems, and need not choose either extreme.

Differences between Flexible and Fixed Exchange Rate System

Some countries (Canada, USA) consistently follow a particular exchange rate while others (Argentina, Russia) shift from one exchange rate to another. Canada has followed a flexible exchange rate since 1971, Hong Kong has had a currency board since 1983 and Argentina moved from a flexible exchange rate to a currency board in 1991. India moved from a fixed exchange rate to a partially floating rate in 1993 and a full float in 1994.

There has been a gradual shift from fixed exchange rate (and its variants) to flexible exchange rate. While a majority of developing countries had a fixed exchange rate in 1975, less than half had a fixed exchange rate 20 years later. Economists advocate a fixed exchange rate when an economy is affected by shifts in the demand for money that can affect price levels.

They advocate a flexible exchange rate when an economy is affected by changes in demand for products. A country that makes a successful transition from a fixed to a floating rate has a deep foreign exchange market, a well thought out policy of intervention by the central bank, and effective mechanisms to manage exchange rate risks.

The pegged exchange rate was popular in the early 1990s among countries that were making the transition to becoming market economies. Countries moved away from the hard peg towards the crawling peg. The efficacy of a particular exchange rate system is a function of each country‘s unique economic circumstances, stage of development, strength of the financial system, and the degree of autonomy enjoyed by its monetary authority. No single exchange rate system has been an unqualified success across countries in terms of improvement in growth rates or financial stability.

The fixed exchange rate did not accelerate growth rates in countries that adopted it, nor did it protect them from currency crises. The same is true of the floating exchange rate. On the other hand, the central banks of many developing countries fear the impact a floating exchange rate would have through a sharp appreciation or depreciation of their currency on their exports and imports, as well as their capacity to repay overseas debt.