Final answer:
Floating exchange rates are determined by global currency markets, while fixed or pegged exchange rates are established by government policy. Governments choose their exchange rate policies to balance stability with economic flexibility, and each policy has its trade-offs.
Step-by-step explanation:
The exchange rates of a country's currency can be categorized into different regimes based on how they are determined. Floating exchange rates exist when exchange rates are determined by the global currency markets, driven by factors such as supply and demand, economic data, geopolitical events, and market sentiment. On the other hand, fixed exchange rates, also known as pegged exchange rates, exist when a government establishes official rates of exchange for its currency, often maintaining this fixed rate by using currency reserves or through monetary policy actions like adjusting interest rates.
Governments may apply different exchange rate policies depending on their economic goals and conditions. A hard peg exchange rate policy might be adopted to reduce exchange rate fluctuations and maintain stability, even though it requires the country's monetary policy to focus on maintaining the exchange rate. Contrarily, a floating exchange rate policy provides more flexibility as the rate adjusts naturally to market forces, but it can lead to more volatility and uncertainty in international trade and investments.
Each exchange rate regime presents its trade-offs, and there is no one-size-fits-all policy. Governments often have to balance the need for stability with the desire for economic agility, and their choice of exchange rate policy is a critical part of this balancing act. These policies can significantly affect a country's economy, influencing inflation, exports, imports, and overall economic growth.