Floating & Fixed Exchange Rates

Hey guys, do you know the foreign exchange market is the largest market in the world? In fact, over $1 trillion is traded in the currency markets on a daily basis. This article is certainly not a primer for currency trading, but it will help you understand exchange rates and why some fluctuate while others do not.

What Is an Exchange Rate?

An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of another country's currency compared to that of your own.

Fixed

A fixed (pegged) rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen, or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.

In order to maintain the rate, the central bank must keep a high level of foreign reserves. This reserved amount can be used to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation), and ultimately, the exchange rate.

Floating

Floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting", as any differences in supply and demand will automatically be corrected in the market. If demand for a currency is low, its value will decrease, and vice – versa.

The World Once Pegged

Between 1870 and 1914, there was a global fixed exchange rate. Currencies were linked to gold, meaning that the value of a local currency was fixed at a set exchange rate to gold ounces. This was known as the gold standard. This allowed for unrestricted capital mobility as well as global stability in currencies and trade; however, with the start of World War I, the gold standard was abandoned.

At the end of World War II, the conference at Bretton Woods, in an effort to generate global economic stability and increased volumes of global trade, established the basic rules and regulations governing international exchange. As such, an international monetary system, embodied in the International Monetary Fund (IMF), was established to promote foreign trade and to maintain the monetary stability of countries and therefore that of the global economy

It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S. dollar, which in turn was pegged to gold at USD 35/ounce. The peg was maintained until 1971, when the U.S. dollar could no longer hold the value of the pegged rate of USD 35/ounce of gold.

From then on, major governments adopted a floating system, and all attempts to move back to a global peg were eventually abandoned in 1985. Since then, no major economies have gone back to a peg, and the use of gold as a peg has been completely abandoned.

Why Peg?

The reasons to peg a currency are linked to stability. Especially in today's developing nations, a country may decide to peg its currency to create a stable atmosphere for foreign investment. With a peg the investor will always know what his/her investment value is, and therefore will not have to worry about daily fluctuations. A pegged currency can also help to lower inflation rates and generate demand, which results from greater confidence in the stability of the currency.

Pegging Problems

Ø Mexican (1995), Asian and Russian (1997) financial crises

Ø Loss of independent monetary policy

Ø Transmission of shocks from anchor country (1995 Mexican Currency Crisis)

Ø Speculative attacks may leads BLACK MARKET which may leads to heavy re/devaluation of currency.

BOTTOM LINE…

In reality, no currency is wholly fixed or floating.

Sources…

Investopedia.com

Research paper from Fredrick Mishkin – Exchange Rate Pegging in Emerging Market Countries.