IB Economics HLTopic 4 — The Global EconomyPaper 1, 2 & 3Evaluation~11 min read
Fixed Versus Floating Exchange Rates
There is no right answer here, which is exactly why examiners like it. A fixed rate buys certainty and pays for it with reserves and lost policy freedom. A floating rate hands you policy freedom and charges you in volatility. Your job in an essay is to say which price is worth paying for the country in front of you.
📚 What you need to know
Fixed: the central bank holds the rate steady by buying and selling its own currency.
Fixed gives stability and predictability for trade and investment, and cuts speculation.
Fixed costs you monetary policy independence and burns through foreign reserves.
Floating: the rate is set by the market and adjusts automatically to shocks.
Floating frees up interest rates for domestic goals, but brings volatility.
Pegs can and do break, usually when defending them becomes too expensive.
The one sentence that frames everything
The core trade-off
A country can have a stable exchange rate, or it can have an interest rate set for its own economy. It cannot fully have both.
Here is why. To hold a peg, the central bank must keep the rate attractive enough that people want the currency at exactly that price. If money starts leaving, it has to raise interest rates to bring it back — even if the domestic economy is in recession and desperately needs a cut. The exchange rate target has hijacked monetary policy.
Fixed exchange rates
✓ STRENGTHS
Certainty. An exporter signing a two-year contract knows exactly what it will be paid.
Investment. Foreign firms are more willing to build here when currency risk is removed.
Less speculation. If the rate is not going to move, there is nothing to bet on.
Inflation discipline. A government cannot let prices run away without the peg coming under pressure.
✗ WEAKNESSES
No independent monetary policy. Interest rates serve the peg, not employment or growth.
Reserves get spent. Every defence of the peg uses up foreign currency the country had to earn.
No automatic adjustment. A trade deficit will not be corrected by the rate falling, because it cannot fall.
Speculators can attack. If they think reserves are running low, they bet against the peg and make it break faster.
Why pegs break
Defending a peg against pressure means selling foreign reserves to buy your own currency. Reserves are a finite stock. Sooner or later the arithmetic wins.
The drop gets steeper because traders can see it coming. Once they believe the peg will break, they sell the currency, which forces the bank to spend reserves faster.
Real example. In January 2015 the Swiss central bank abandoned its floor of 1.20 Swiss francs to the euro. It had been printing and selling francs on a huge scale to hold that floor, and decided the cost was no longer worth it. The franc jumped in value within minutes, hurting Swiss exporters and tourism and causing losses for anyone holding franc positions.
Floating exchange rates
✓ STRENGTHS
Monetary policy is free. Interest rates can target inflation, growth and jobs at home.
Automatic adjustment. A trade deficit puts downward pressure on the currency, which makes exports cheaper and starts fixing the deficit on its own.
No reserves needed. The central bank does not have to hold a war chest to defend anything.
Shock absorber. When a big export market slumps, the currency falls and softens the blow.
✗ WEAKNESSES
Volatility. Firms cannot be sure what a contract will be worth in six months.
Speculation. Rates can swing on rumours rather than on the real economy.
Imported inflation. A sharp fall raises the cost of imported food, fuel and components.
Discourages investment. Currency risk raises the return foreign investors demand before they will commit.
Side by side
Feature
Fixed exchange rate
Floating exchange rate
Who decides the rate
The central bank, by intervening
Market forces of demand and supply
Certainty for traders
High — the rate is known in advance
Low — the rate can move any day
Monetary policy
Tied to defending the rate
Free to target domestic goals
Foreign reserves
Large holdings required
Not required for this purpose
Response to a shock
Must be absorbed by output and jobs
Absorbed partly by the currency itself
Speculation
Reduced, until the peg looks weak
Ongoing, and can be destabilising
The trade-off in one picture
Economists sum this whole debate up with three goals that cannot all be met at once. Pick any two and you have automatically given up the third.
This is the cleanest way to explain why a pegged country cannot cut rates in a recession. It has already spent that option on the peg.
Switching from one system to the other
Abandoning a peg is not a technical adjustment. It is a shock, and it hits several parts of the economy at once.
What happens
Why it matters
The currency jumps
Once the artificial rate is removed, the market price appears immediately and can be far from the old peg.
Exporters are squeezed
If the currency jumps up, their goods become dearer abroad overnight and orders are lost.
Tourism suffers
A dearer currency makes the country an expensive place to visit, so visitor numbers fall.
Financial losses
Anyone holding contracts based on the old rate can lose heavily in a single day.
Price pressure changes direction
A stronger currency makes imports cheaper, which can tip an economy towards deflation.
Neighbours are affected
Trading partners see their own competitiveness change without doing anything themselves.
Worked examples
WORKED EXAMPLE 1
A country with a fixed exchange rate enters a recession. Explain why it may struggle to respond. [4]
Step 1: what it would normally do
Cut interest rates to boost consumption and investment, raising AD.
Step 2: what a rate cut does to the currency
Lower returns mean investors move money out, so supply of the currency rises and it comes under downward pressure.
Step 3: the conflict
To hold the peg the bank must sell reserves or raise rates back — the opposite of what the recession needs.
The peg has taken away its main toolwith a floating rate the currency would have fallen instead, boosting exports and helping the recovery by itself
WORKED EXAMPLE 2
Evaluate whether a small developing economy that exports mainly one primary commodity should adopt a fixed exchange rate. [15-style plan]
Case for fixing
Commodity prices swing wildly, so a stable currency removes one more source of uncertainty for exporters and foreign investors. It also imposes discipline on inflation.
Case against fixing
When the world price of its commodity falls, export earnings collapse. A floating rate would depreciate, cushioning the blow. A peg forces the whole adjustment onto jobs and wages instead.
The practical problem
Defending a peg needs large reserves, and a small economy dependent on one commodity is exactly the kind that struggles to build them.
Judgement
A managed system is often the realistic answer: some stability, but room to let the rate move when a commodity shock arrives.
Depends on reserve size, shock frequency and how open capital markets arealways name what your judgement depends on — that is where the evaluation marks live
💡 Exam tip
Frame every answer around the stability versus policy freedom trade-off. It works for any version of this question.
Bring in reserves. A peg is only credible while the reserves behind it are.
Mention automatic adjustment: it is the strongest single argument for floating and many answers miss it.
Use a real case in one sentence. The 2015 Swiss decision is short, clear and shows what happens when a peg is dropped.
End with what it depends on: economy size, reserve holdings, trade openness and how volatile its export markets are.
⚠ Common mix-up
Fixed does not mean permanent. Pegs are changed by revaluation and devaluation, and sometimes abandoned entirely.
Floating is not “no policy”. Central banks still influence the rate through interest rates and occasional intervention.
Speculation is not only a floating rate problem. Pegs attract the biggest speculative attacks of all, precisely because there is a known level to bet against.
Stability is not costless. The cost is the interest rate the country can no longer choose.
Do not sit on the fence. “It depends” only earns marks when you say what it depends on.
Up next: The Components of the Balance of Payments — the accounts that record every pound, dollar and euro crossing a country’s border.
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