Fixed vs.

Floating Exchange Rate Systems: A Critical Assessment in the Context of

Developing Economies
Introduction
The exchange rate regime a country adopts significantly influences its macroeconomic
stability, trade performance, and investment climate. This essay distinguishes between these
systems, explores the preference of developing and emerging economies for fixed exchange
rates, and evaluates whether exchange rate volatility under floating regimes affects trade. The
discussion includes recent empirical findings, country-specific examples, and relevant charts
to support critical evaluation.
Fixed vs. Floating Exchange Rates: Conceptual Differences
A fixed exchange rate system pegs a country's currency to another stable currency (like the
USD or euro), maintaining it within a narrow band. The central bank intervenes in the foreign
exchange market, buying or selling reserves to maintain the peg (Krugman & Obstfeld,
2022). Conversely, a floating exchange rate system allows the value of the currency to be
determined by supply and demand without direct central bank intervention (Copeland, 2021).
The primary advantage of fixed exchange rates is the predictability they provide for
international trade and investment. Businesses can plan for the future with reduced exchange
rate risk, making pricing, costing, and contract management more manageable. In contrast,
floating rates reflect underlying economic fundamentals and allow for automatic external
adjustment, which is beneficial in absorbing external shocks, such as commodity price
changes (IMF, 2023).

Why Developing Countries Prefer Fixed Exchange Rates

Despite the theoretical flexibility of floating rates, many developing countries opt for fixed or
managed exchange rates. This preference is underpinned by several practical and political-
economic considerations:
1. Inflation Control and Monetary Discipline
Emerging markets often suffer from weak monetary institutions. Fixing the exchange rate to a
stable foreign currency imposes external discipline, helping to curb inflation. For instance,
Argentina's currency board in the 1990s, which pegged the peso to the US dollar, helped
bring hyperinflation under control (Edwards, 2018). Although the peg eventually collapsed,
the case illustrates the initial stabilising effect of fixed regimes.
2. Trade and Investment Promotion
A stable exchange rate reduces transaction costs and uncertainty in cross-border trade. Since
many developing economies are export-oriented, especially in primary commodities, stable
rates encourage investment and long-term trade contracts. For example, West African
countries in the CFA franc zone maintain a peg to the euro, promoting regional trade and
macroeconomic stability (Kose et al., 2021).
3. Credibility and Investor Confidence
Pegging the currency can signal commitment to sound economic policies, enhancing
credibility with foreign investors and multilateral lenders. In economies with volatile political
environments or weak policy frameworks, a fixed rate may compensate for institutional
fragility.
4. Limited Financial Market Depth
Developing countries often lack deep and liquid foreign exchange markets. A floating system
could lead to excessive volatility, unconnected to fundamentals, due to speculative flows or
panic, especially in economies with low reserve buffers (Reinhart & Rogoff, 2004).

Drawbacks of Fixed Exchange Rates in Practice

While attractive for short-term stabilisation, fixed exchange rates can become problematic:
 Loss of monetary policy autonomy: A pegged system constrains a country’s
ability to use interest rates for domestic objectives (Blanchard, 2021).
 Risk of speculative attacks: If markets perceive the peg as unsustainable,
central banks may deplete reserves defending it, leading to painful
devaluations—as seen in Thailand during the 1997 Asian Financial Crisis.
 Real exchange rate misalignments: Persistent inflation differentials can render
a country’s exports uncompetitive under a fixed regime.
To mitigate these issues, many countries adopt “managed float” or intermediate regimes,
adjusting the currency within a band or in response to market signals (Ghosh, Ostry &
Tsangarides, 2022).

Exchange Rate Volatility and Trade under Floating Regimes

A key concern under floating regimes is exchange rate volatility and its effect on trade. The
theoretical relationship is ambiguous: while volatility increases risk, floating rates can also
adjust to maintain competitiveness.
Empirical Evidence
Empirical studies suggest that high exchange rate volatility can reduce trade volumes,
especially in sectors with thin margins or long planning horizons (Taglioni & Winkler, 2021).
For example, a 2022 study by Bussière et al. (OECD) showed that in Sub-Saharan Africa,
fluctuations in exchange rates reduced bilateral trade by 10–15% over a five-year period.
However, the impact varies by sector and region. High-value, low-volume industries (e.g.,
technology) are less affected, while agriculture and manufacturing face greater risk.
Moreover, firms often hedge exchange rate risk using financial instruments, although such
tools are less available in developing economies.
The magnitude of exchange rate volatility’s impact on trade also depends on a country’s
institutional quality, financial infrastructure, and export composition. In developing
economies like Tanzania or Ghana, where capital markets are underdeveloped and firms lack
sophisticated hedging mechanisms, volatility leads to significant cost uncertainty. This
uncertainty discourages long-term trade contracts and foreign investment (Amiti, Itskhoki &
Konings, 2022). Moreover, small and medium enterprises (SMEs), which dominate exports
in many emerging economies, often operate on thin profit margins and are particularly
vulnerable to sudden exchange rate swings. Volatility can also distort price signals, making it
difficult for exporters to set competitive prices abroad. While floating regimes theoretically
allow for automatic adjustment to external shocks, in practice, persistent fluctuations may
undermine exporter confidence and delay investment in export-oriented infrastructure. To
mitigate these effects, some countries use managed float systems, combine monetary policy
tools with trade stabilization funds, or maintain currency swap arrangements with trade
partners.
Conclusion
In theory, floating exchange rates provide macroeconomic flexibility, but in practice,
developing countries often favour fixed or managed regimes due to their benefits in inflation
control, trade promotion, and credibility. Fixed exchange rates offer a stabilising force in
economies with weak institutions, shallow financial markets, and high political uncertainty.
Nevertheless, exchange rate volatility under floating regimes can deter trade, particularly in
emerging markets with limited access to hedging tools. While no system is without flaws,
countries must tailor their exchange rate regimes to their institutional capacity, economic
structure, and external vulnerabilities.
References
Blanchard, O. (2021) Macroeconomics. 8th edn. Boston: Pearson.
Bussière, M., De Nicola, F., & Héricourt, J. (2022) ‘Exchange Rate Volatility and Trade: A
Re-examination Using Sectoral Data’, OECD Working Papers, 173.
Copeland, L. (2021) Exchange Rates and International Finance. 7th edn. Harlow: Pearson.
Edwards, S. (2018) Crisis and Reform in Latin America: From Despair to Hope. Oxford:
Oxford University Press.
Ghosh, A., Ostry, J. D. & Tsangarides, C. G. (2022) ‘Exchange Rate Regimes and the
Stability of the International Monetary System’, IMF Economic Review, 70(1), pp.
34–67.
IMF (2023) World Economic Outlook: Trade and Tensions. Washington D.C.: International
Monetary Fund.
Kose, M. A., Ohnsorge, F., & Sugawara, N. (2021) ‘A Cross-Country Database of Fiscal
Space’, World Bank Policy Research Paper, 8897.
Krugman, P. R. & Obstfeld, M. (2022) International Economics: Theory and Policy. 11th
edn. Harlow: Pearson.
Reinhart, C. M. & Rogoff, K. S. (2004) ‘The Modern History of Exchange Rate
Arrangements: A Reinterpretation’, Quarterly Journal of Economics, 119(1), pp. 1–
48.
Taglioni, D. & Winkler, D. (2021) Making Global Value Chains Work for Development.
Washington, D.C.: World Bank.