Fixed versus Floating Exchange Rates
Countries choose an exchange-rate regime. Under a floating rate the market sets the currency’s value, while under a fixed (pegged) rate the central bank commits to a level and buys or sells reserves to defend it. Many run a managed float in between. The choice is bound by the trilemma, the rule that a country cannot have a fixed exchange rate, free capital flows, and an independent monetary policy all at once.
Try it yourself
The Policy Trilemma
A country can lock in at most two of these three goals at once. Switch on the two you want and see which one you are forced to give up.
Reflection: the eurozone fixes exchange rates between members and allows free capital, so each member gives up its own monetary policy to the ECB. Which corner did your country choose, and what did it pay to keep the other two?
Why it matters
A peg buys stability and an inflation anchor but spends reserves and surrenders monetary independence. Floating keeps monetary policy free but lets the currency swing. The trilemma means you only get to pick two of the three.
Worked examples
A country pegs its currency, lets capital flow freely, and also wants to cut interest rates to fight a recession. Why is this hard?
The trilemma blocks it. Cutting rates with free capital flows sends money abroad chasing higher returns, which pushes the currency down and breaks the peg unless the central bank burns reserves. The country has to give up one of the three.
Common mistakes
- ✗A fixed exchange rate is always more stable and therefore better. A peg can collapse suddenly when reserves run low, and defending it can force painful interest-rate hikes.
- ✗Floating rates mean the central bank never intervenes. Most run a managed float and step in to smooth large swings.
Revision bullets
- •Floating (market-set) vs fixed (defended peg), with managed floats between
- •A peg is defended by buying and selling reserves
- •Trilemma: pick two of fixed rate, free capital, policy independence
Quick check
The policy trilemma says a country cannot simultaneously have
Connected topics
Sources
- Mishkin (2018), Ch. 19Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.Exchange-rate regimes, fixed versus floating rates, and the policy trilemma.