Currency Exchange: Floating Rate Vs. Fixed Rate

There are different ways the price of a currency can be determined against another. A fixed (nominal) 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. The second way, a floating exchange rate, is determined by the private market through supply and demand and may be termed as “ self-correcting ”.

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 or her investment's 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.

Fixed regimes, however, can often lead to severe financial crises since a peg is difficult to maintain in the long run. This was seen in the Mexican (1995), Asian (1997) and Russian (1997) financial crises: an attempt to maintain a high value of the local currency to the peg resulted in the currencies eventually becoming overvalued. This meant that the governments could no longer meet the demands to convert the local currency into the foreign currency at the pegged rate. With speculation and panic, investors scrambled to get their money out and convert it into foreign currency before the local currency was devalued against the peg; foreign reserve supplies eventually became depleted. In Mexico's case, the government was forced to devalue the peso by 30%. In Thailand, the government eventually had to allow the currency to float, and by the end of 1997, the Thai that had lost 50% of its as the market's demand and supply readjusted the value of the local currency.

Under the fixed exchange rate system, a decrease in the exchange rate which is infrequent are called revaluations. While an increase in the exchange rate are called devaluations. A devaluation in a fixed exchange rate will cause the current account balance to rise, making a country's export less expensive for foreigners and also discourage import by making import products more expensive for domestic consumers,. This will leads to an increase in trade surplus or a decrease in trade deficit. The opposite happens in a revaluation

The floating exchange rate is a market-driven price for currency, whereby the exchange rate is determined entirely by the free market forces of demand and supply of currencies with no government intervention whatsoever.

Broadly, the floating exchange rate regime consists of the independent floating system and the managed floating system. The former is where exchange rate is strictly determined by the free movement of demand and supply. For managed floating system, exchange rate is also determined by free movement of demand and supply but the monetary authorities intervene at certain times to "manage" the exchange rate to prevent high volatilities.

The floating exchange rate boasts various merits. Firstly, there is automatic correction in the floating exchange rate as the country simply lets it move freely to the equilibrium of demand and supply. Secondly, there is insulation from external economic events as the country's currency is not tied to a possibly high world inflation rate as is under a fixed exchange rate.

A pegged exchange rate system is a hybrid of fixed and floating exchange rate regimes. Typically, a country will "peg" its currency to a major currency such as the U.S. dollar, or to a basket of currencies. The choice of the currency (or basket of currencies) is affected by the currencies in which the country's external debt is denominated and the extent to which the country's trade is concentrated with particular trading partners. The case for pegging to a single currency is made stronger if the peg is to the currency of a principal trading partner. If much of the country's debt is denominated in other currencies, the choice of which currency to peg it to becomes more complicated. With a pegged exchange rate, an initial target exchange rate is set and the actual exchange rate will be allowed to fluctuate in a range around that initial target rate. Also, given changes in economic fundamentals, the target exchange rate may be modified.

Although the peg has worked in creating global trade and monetary stability, it was used only at a time when all the major economies were a part of it. And while a floating regime is not without its flaws it has proved to be a more efficient means of determining the long-term value of a currency and creating equilibrium in the international market.

The adoption and elimination of several global currency systems over time led to the formation of the present currency exchange system, in which most countries use some measure of floating exchange rates.

Дата добавления: 2015-10-30