Confidence votes 33

There are two ways the price of a currency can be determined against another. A fixed, or 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.

If, for example, it is determined that the value of a single unit of local currency is equal to USD 3.00, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank which it can use 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. The central bank can also adjust the official exchange rate when necessary.

Floating

Unlike the fixed rate, a 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. Take a look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and thus stimulating demand for local goods and services. This in turn will generate more jobs, and hence an auto-correction would occur in the market. A floating exchange rate is constantly changing.

In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence changes in the exchange rate. Sometimes, when a local currency does reflect its true value against its pegged currency, a black market which is more reflective of actual supply and demand may develop. A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of the black market.

In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation; however, it is less often that the central bank of a floating regime will interfere.

Fixed vs. Flexible Fixed advantages A fixed exchange rate should reduce uncertainties for all economic agents in the country. As businesses have the perfect knowledge that the price is fixed and therefore not going to change they can plan ahead in their productions. Inflation may have a harmful effect on the demand for exports and imports. To ensure that inflation is kept as low as possible the government is forced to take measurements, to keep businesses competitive in foreign markets. In theory a fixed exchange rate should also reduce speculations in foreign exchange markets. In reality this is not always the case as countries want to make speculative gains.

Fixed Disadvantages The government is keeping the exchange rate fixed by manipulating the interest rates. If the exchange is in danger of falling the government needs to increase interest rates to increase demand for the currency. As this would have a deflationary effect on the economy the demand might decrease and unemployment might increase. A government has to maintain high levels of foreign reserves to keep the exchange rate fixed as well as to instill confidence on the foreign exchange markets. This makes clear that a country is able to defend its currency by the buying and selling of foreign currencies. Fixing the exchange rate is not easy as there are many variables which are changing over time if the exchange rate is set wrong it might be hard for export companies to be competitive in foreign countries. International disagreement might be created when a country sets its exchange rate on a too low level. This would make a countries export more competitive which might lead to a disagreement between countries as they might see it as an unfair trade advantage.

Flexible Advantages As the exchange rate does not have to be kept at a certain level anymore interest rates are free to be employed as domestic management policies(Appleyard 703). The floating exchange rate is adjusting itself to keep the current account balanced, in theory. As the reserves are not used to control the value of the currency it is not necessary to keep high levels of reserves (like gold) of foreign countries.

Flexible Disadvantages Floating exchange rates tend to create uncertainty on the international markets. As businesses try to plan for the future it is not easy for the businesses to handle a floating exchange rate which might vary. Therefore investment is more difficult to assess and there is no doubt that excursive exchange rates will reduce the level of international investment as it is difficult to assess the exact level of return and risk. Floating exchange rates are affected by more factors than only demand and supply, such as government intervention. Therefore they might not necessarily adjust themselves in order to eliminate current account deficits. The floating exchange rate might worsen existing levels of inflation. If a country has higher inflation rate than others this will make the export of the country less competitive and its imports more expensive. Then the exchange rate will fall which could lead to even higher import prices of goods and because of cost-push inflation which might drive the overall inflation rate even more. While flexible exchange rates can ensure that the country achieves external balance, they do not ensure internal balance. In several situations the exchange rate change that reestablishes external balance can make an internal imbalance worse. If a country has rising inflation and a tendency toward external deficit, the depreciation of the currency can intensify the inflation pressures in the country. If a country has excessive unemployment and a tendency toward surplus, the appreciation of the currency can make the unemployment problem worse. To achieve internal balance, the country’s government may need to implement domestic policy changes.