It can also be so because exchange rates sometimes overshoot their long-run values. The market corrects the rate automatically reflecting inflation and other market conditions influencing the economy.
In this system, a currency links its value to another but gives it fluctuation limits and is immensely valuable if a currency linking itself has expectations of being volatile exceptionally, hence allowing itself to fluctuate to a level acceptable under the conditions. In this system, the authorities determine the value around which the currency can fluctuate.
Fixed exchange rate system
Here, a currency has a direct convertibility towards another currency with the government trying to keep the value constant against the other currency. The government decrees the worth of its currency against the value of another, plus rules of the exchange.
b) Advantages and disadvantages of Floating rate exchange system
Flexibility, which enhances the capability of the country market economy to pick up and adjust quickly to the changing market conditions, is the main advantage of this system.
In case of a violation of the balance of payments deficit, this system of exchange allows for adjustment of outflow and/or inflow making either domestic or foreign goods more competitive depending on whether there was appreciation or depreciation in the currency market.
Another advantage is the automatic determination of interest rates within the country, allowing efficient control of the economic balance. A country gets insulated from unemployment problems in other countries. This is because currency exchange rate adjustments normally serve as protection against exportation of financial problems to other countries. Disadvantages This system does not stimulate trade development and production, hence leading to market instability. Further, it destabilizes the financial situations and leads to economic crises. This causes uncertainty in trade; it may be uncertain to entrepreneurs the amount of money they get by selling their goods abroad or their prices in foreign countries. Likewise, importation will be uncertain since they may never know the cost of importing foreign goods. Another disadvantage is that the uncertainty it causes may discourage investment either internally or externally. Additionally, it leads to speculation which is a serious economic destabilization since the speculative flows may contradict the trade flow patterns. Fixed rate Advantages This system offers exceptional economic stability for ventures, besides stimulating multinational trade. This is because the exchange rates remain on the same level making the importers and exporters plan their business policies without speculations of depreciation or appreciation of the money. This system also makes producers disciplined since they oblige to keeping up the pace and quality of their production; controlling the cost of their production and staying internationally competence (Madura2003, p. 304). Additionally, this system stimulates reduction of worldwide speculation if the exchange rate is profitable to both foreign and domestic investors. Disadvantages This system is highly vulnerable to speculative attacks. It may cause inability to cover gaps between existing resources and demand in case of excess supply and demand in either