An exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency. Each country determines itsthe exchange rate regime. For example, the currency may be fixed or floating.
So even a country that country professes that it has a floating exchange rate system does intervene often in the forex markets to obtain a 'desired' level of exchange rate. That is how countries end up having only a managed float. That is they will allow their currency to float (i.e., have its exchange rate with other currencies fluctuate according to market determined forces) within a certain acceptable upper and lower bands. Only when they fail to contain it within those bands does it really become a floating currency. Thus, a fully floating currency is an idealistic situation. Free economies claim that their currency is floating. What they are referring to is their managed float only. Even the US does manage the dollar's exchange rate to a certain extent.
[Following] the traditional literature in assuming that prices are set in producers' currencies, and that the law of one price holds, there is no clear-cut answer on which regime is preferable. […] However, the empirical evidence supports the model of pricing in which producers set different prices in different markets. Prices are set in consumers' currencies and adjust slowly to demand shocks. In that case, we find that floating exchange raes are unambiguously preferred to fixed exchange rates.
Corporations have the choice to borrow a a fixed rate or at a rate that varies over time with the level of short-term interest rates. As Cornell argued, this choice should reflect the firm's operating exposure to unexpected changes in the rate of inflation. For companies whose operating cash flow is positively correlated with inflation, floating rate debt provides a long-term hedge against inflation risk. […] By contrast, companies whose operating profits do not keep pace with unanticipated inflation could eliminate interest rate risk by fixing the amount of interest payments on the debt.
...volatility under flexible rates is due in part to the order-flow factor in returns. Under flexible rates, the elasticity of public demand is (endogenously) low. Low elasticity is both a result of, and a cause of, higher volatility. […] Under (perfectly credible) fixed rates, the elasticity of public demand is infinite, so portfolio-balance effects do not arise, and there is nothing for the market to learn from order flow.
Empirical studies show that trade grows at approximately the same are during periods of fixed rates and floating rates. Floating exchange rates therefore does not seem harmful for exploiting the benefits of tad, in general. Of course, this does not exclude the possibility that trade could have grown even faster if the exchange rate fluctuations were decreased. But, compared to periods of fixed exchange rates, flexible exchange rates do not seem to hinder trade.
…the fundamental difference in floating and fixed exchange rate system is in the monetary policies each system milieus. […there are] two reasons [why] a country may want to commit to a fixed exchange rate for a number of periods. One is the constraint fixed exchange rates place on budget policy. Commitment does not allow a country to inflate more in order to finance an expanded government budget deficit, so it constrains budget policy. […] The second reason for commitment to a fixed exchange rate is that it may protect the interests of future generations.
Volatility and risk refers to the tendency for exchange rates to change and the effect these changes have on the risk faced by traders and investors. Although in floating exchange systems volatility is a natural day-to-day occurrence, even in fixed exchange systems, devaluations or revaluations make volatility an issue. [...] Inflationary consequences are shown to be a major potential problem for countries with floating exchange rates. For many countries facing this problem, fixed exchange rate systems can provide relief. [...] Finally, monetary autonomy, and the ability to control the economy, is lost with the choice of fixed exchange rates.
Many economists argue that a flexible exchange rate regime is preferable to a fixed exchange rate regime because it helps to insulate the domestic economy from adverse external shocks. For example, when export demand declines, a depreciation makes domestic goods more competitive abroad, stimulates an offsetting expansion in demand, and dampens the contraction in domestic economic activity. In reality, however, exchange rate depreciations in many emerging market economies over the past decade typically have been associated with financial distress and output contractions. Consequently, recent research has reconsidered the stabilization properties of a flexible exchange rate regime when exchange rate movements affect financial conditions, and these, in turn, influence economic activity.
The main economic advantages of floating exchange rates are that they leave the monetary and fiscal authorities free to pursue internal goals -- such as full employment, stable growth, and price stability -- and exchange rate adjustment often works as an automatic stabilizer to promote those goals. The main economic advantage of fixed exchange rates is that they promote international trade and investment, which can be an important source of growth in the long run, particularly for developing countries.
Exchange rates between currencies have been highly unstable since the collapse of the Bretton Woods system of fixed exchange rates, which lasted from 1946 to 1973. Under the Bretton Woods system, exchange rates (e.g., the number of dollars it takes to buy a British pound or German mark) were fixed at levels determined by governments. Under the "floating" exchange rates we have had since 1973, exchange rates are determined by people buying and selling currencies in the foreign-exchange markets. The instability of floating rates has surprised and disappointed many economists and businessmen, who had not expected them to create so much uncertainty.