Fixed and Floating Exchange Rate Regime

 

 Fixed and Floating Exchange Rate Regime

Floating Rate vs. Fixed Rate: An Overview
More than $5 trillion is traded in the currency markets on a daily basis, as of
2018. 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. If you are traveling to another country, you need to "buy"
the local currency. Just like the price of any asset, the exchange rate is the price
at which you can buy that currency.
If you are traveling to Egypt, for example, and the exchange rate for U.S.
dollars is 1:5.5 Egyptian pounds, this means that for every U.S. dollar, you can
buy five and a half Egyptian pounds. Theoretically, identical assets should sell
at the same price in different countries, because the exchange rate must maintain
the inherent value of one currency against the other.
Floating Rates
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. Look at this simplified model: if demand for a currency
is low, its value will decrease, thus making imported goods more expensive and
stimulating demand for local goods and services. This, in turn, will generate
more jobs, causing an auto-correction 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 reflects 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 Rate
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 US$3, 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 that 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.
Special Considerations
Between 1870 and 1914, there was a global fixed exchange rate. Currencies
were linked to gold, meaning that the value of 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, an effort to
generate global economic stability and increase 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 $35 per ounce. What this
meant, was that the value of a currency was directly linked with the value of the
U.S. dollar. So, if you needed to buy Japanese yen, the value of the yen would
be expressed in U.S. dollars, whose value, in turn, was determined in the value
of gold. If a country needed to readjust the value of its currency, it could
approach the IMF to adjust the pegged value of its currency. The peg was
maintained until 1971 when the U.S. dollar could no longer hold the value of
the pegged rate of $35 per 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.
Key Differences
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 bhat had lost 50% of its value as the market's demand and supply
readjusted the value of the local currency.
Countries with pegs are often associated with having unsophisticated capital
markets and weak regulating institutions. The peg is there to help create
stability in such an environment. It takes a stronger system as well as a mature
market to maintain a float. When a country is forced to devalue its currency, it is
also required to proceed with some form of economic reform, like implementing
greater transparency, in an effort to strengthen its financial institutions.
Some governments may choose to have a "floating," or " crawling " peg,
whereby the government reassesses the value of the peg periodically and then
changes the peg rate accordingly. Usually, this causes devaluation, but it is
controlled to avoid market panic. This method is often used in the transition
from a peg to a floating regime, and it allows the government to "save face" by
not being forced to devalue in an uncontrollable crisis. 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. While a floating regime is
not without its flaws, it has proven to be a more efficient means of determining
the long-term value of a currency and creating equilibrium in the international
market.
Key Takeaways
 A floating exchange rate is determined by the private market through
supply and demand.
 A fixed, or pegged, rate is a rate the government (central bank) sets and
maintains as the official exchange rate.
 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.
Major Fixed Currencies
 Below is a list of some of the national economies and the corresponding rates that
currently peg to the U.S. dollar as of October 2018.
Country Region Currency Name Code Peg Rate Rate Since
Bahrain Middle East Dollar BHD 0.376 2001
Belize Central America Dollar BZ$ 2.00 1978
Cuba Central America Convertible Peso CUC 1.000 2011
Djibouti Africa Franc DJF 177.721 1973
Eritrea Africa Nakfa ERN 10.000 2005
Hong Kong Asia Dollar HKD 7.75-7.85 1998
Jordan Middle East Dinar JOD 0.709 1995
Lebanon Middle East Pound LBP 1507.5 1997
Oman Middle East Rial OMR 0.3845 1986
Panama Central America Balboa PAB 1.000 1904
Qatar Middle East Riyal QAR 3.64 2001
Saudi Arabia Middle East Riyal SAR 3.75 2003
United Arab Emirates Middle East Dirham AED 3.6725 1997
 Source: Investmentfrontier.com