Fixed, Floating and Dirty Float | Foreign Exchange Tutorials

Fixed, Floating and Dirty Float in Foreign Exchange

Fixed, floating, and dirty float are different exchange rate systems used in foreign exchange.

Fixed exchange rate system: In a fixed exchange rate system, a country’s government or central bank sets a fixed exchange rate for its currency against another currency, usually the US dollar or a basket of currencies. The exchange rate is maintained by the central bank through buying or selling its currency in the foreign exchange market to keep the exchange rate within a specified range. Under a fixed exchange rate system, the exchange rate is stable, but it can create problems if the exchange rate is overvalued or undervalued, leading to trade imbalances and economic distortions.
Floating exchange rate system: In a floating exchange rate system, the exchange rate is determined by the market forces of supply and demand. The central bank may intervene in the market to smooth out short-term fluctuations, but it does not set a target exchange rate. Under a floating exchange rate system, the exchange rate can fluctuate widely, but it can also help to adjust for economic imbalances and shock absorbers.
Dirty float exchange rate system: A dirty float is a hybrid system between a fixed and floating exchange rate system. In a dirty float system, the central bank may set an exchange rate target range and intervene in the foreign exchange market to keep the exchange rate within the range. However, the central bank may also allow the exchange rate to fluctuate outside the range if necessary, to maintain the country’s competitiveness in international trade. The term “dirty” refers to the fact that the central bank intervenes in the market to influence the exchange rate, but the intervention is not as frequent as in a fixed exchange rate system.

Each exchange rate system has its advantages and disadvantages and is chosen by a country based on its economic situation and policy objectives.

Practice Questions

1. Under a fixed exchange rate system, the exchange rate is determined by:
A) Market forces of supply and demand
B) The government or central bank
C) Speculators
D) None of the above

Answer: B

2. In a floating exchange rate system, the exchange rate is determined by:
A) The government or central bank
B) Market forces of supply and demand
C) Speculators
D) None of the above

Answer: B

3. What is a dirty float exchange rate system?
A) A fixed exchange rate system
B) A floating exchange rate system
C) A hybrid system between fixed and floating exchange rates
D) A type of exchange rate used in international trade

Answer: C

4. Which exchange rate system is known for its exchange rate stability?
A) Fixed exchange rate system
B) Floating exchange rate system
C) Dirty float exchange rate system
D) Both A and C

Answer: A

5. How does a central bank intervene in the foreign exchange market under a dirty float exchange rate system?
A) It sets a fixed exchange rate
B) It allows the exchange rate to fluctuate widely
C) It sets an exchange rate target range and intervenes to keep the exchange rate within the range
D) It does not intervene in the foreign exchange market

Answer: C