Explaining the difference between fixed and floating exchange rates

Explaining the difference between fixed and floating exchange rates

15.05.17



If you’re a frequent traveller or an expat, dealing with exchange rates is probably a reality of life. In fact, you’ve probably looked at how to get the best deal on it several times.

But, have you ever wondered what an exchange rate actually is and how it’s worked out?

More to the point, why do some rates change every so often whilst others always seem to stay the same?

If you’re looking for the answer to these and other questions on exchange rates, read on.

What is an exchange rate?


An exchange rate is the value of one currency when compared to another. In other words, it’s how much it costs to buy a sum of foreign money using your local currency.

There are two main types of exchange rates: floating and fixed. Let’s have a look at the difference between the two.

Floating (flexible) exchange rate


A floating exchange rate is based on market forces. It goes up or down according to the laws of supply and demand.

If a currency is widely available on the market - or there isn’t much demand for it - its value will decrease. On the other hand, when a currency is in short supply or in high demand, the exchange rate will go up.

Supply and demand explained


Broadly speaking, the supply and demand for currency depends on three main factors:

1. international trade
2. foreign investment
3. interest rates

International trade


Countries buy from (import) and sell (export) to other countries constantly.

When a country imports products or services, it usually has to pay for them in the other country’s currency. This creates demand for that currency. The more in demand a country’s products and services are, the more in demand its currency will be, which increases its value.

At the same time, the more a country imports, the more foreign currency it will need in order to pay for those products and services. This increases the supply of its own currency on the market. Because there’s more of it available, its value decreases.

Foreign investment


When you decide to invest in a foreign country - by starting a business, or expanding your operations, for example - you’ll need to use that country’s currency. That’s how you’ll pay startup and ongoing business costs such as rent, utilities and wages.

Obviously, you’ll need to buy that country’s money to do this, which increases the demand for that currency and the supply of your local currency on the international market. The more foreign investment a country attracts, the more in demand its currency will be, which increases its value and raises the exchange rate.

Interest rates


Put simply, interest is the cost of borrowing money.

Interest rates can work much in the same way as exchange rates do. They also can either be fixed or vary depending on the supply and demand for credit.

Their relationship with exchange rates is rather complicated. However, as a general rule, higher interest rates increase a currency’s value and demand, which raises the exchange rate.

Summary

                             High                                 Low
Supply    exchange rate goes down    exchange rate goes up
Demand    exchange rate goes up    exchange rate goes down


Fixed (pegged) exchange rate


A fixed exchange rate is officially set by the government and kept at a constant level by using two methods:

1. pegging
2. manipulating market forces to control supply and demand


Pegging


When a currency is pegged, its value is fixed to that of another currency. This means you’ll always get the same amount of money whenever you exchange the two currencies, because the exchange rate is always the same.

Of course, this also means that the value of the pegged currency relative to other currencies will rise and fall with the value of the currency it’s pegged to.

Confused?

Let’s put it in context.

Most countries with a fixed exchange rate peg their currency to the US Dollar. These include oil-rich Middle Eastern countries such as Saudi Arabia and Qatar, as well as international financial centres such as Hong Kong.

Trade with the United States is the main source of income for many of these countries. It makes sense for them to peg their currency to the Dollar, because it ensures they’ll always get more or less the same amount of money whenever they do business.

The US Dollar is also the most widely held foreign currency by Central Banks around the world, and it’s always in demand. This makes it the strongest and most powerful currency around.

Many countries peg their currency to the Euro for similar reasons. Central African countries such as Cameroon, Chad and Gabon used to be European colonies; and they still do most of their business with the European Union. Pegging their currency to the Euro keeps their income at a stable level.

Basket peg


Rather than pegging to one single currency, some countries with a fixed exchange rate peg their currency in a basket peg: a range of other currencies in different percentages. So, for example, a currency with a basket peg might be pegged 25% to the Euro, 20% to the US Dollar, 40% to the British Pound and 15% to the Japanese Yen.

Countries choose a basket peg for the same reason investors diversify their portfolio: they’re spreading the risk of changes in value over several different currencies. Currencies with a basket peg include the Singaporean Dollar and the Kuwaiti Dinar.

Manipulating market forces


Pegging a currency isn’t enough to keep the exchange rate fixed.

The government will also have to monitor the market and take active steps to control the effect of market forces on the exchange rate. This can be done in three main ways:

1. buying or selling foreign currency
2. increasing or decreasing the country’s interest rates
3. prohibiting or restricting foreigners from buying certain products or services or making investments

These actions have an effect on the currency’s supply and demand. If done carefully they’ll help keep the exchange rate at a level that’s more or less constant.

The managed floating approach


Rather than going for a fully floating or fixed exchange rate, some countries - Argentina and Egypt, for example - adopt a “mixed” approach: a managed floating exchange rate.

This type of exchange rate goes up and down freely according to the laws of supply and demand, but only within a given range. The government will intervene whenever the exchange rate risks going too low or getting too high.

Which type of exchange rate is better?


As you might have expected, there’s no right or wrong answer to this question.

Fixed and floating exchange rates both have their advantages and disadvantages. Which approach works best really depends on a given country’s economic realities.

Advantages and disadvantages of a floating exchange rate


A floating exchange rate’s main advantage is that it adjusts itself automatically. There is no need to monitor the market and take any action, because the currency’s value rises and falls depending on supply and demand.

This also frees up resources and removes the need for complicated laws to control the country’s cash flow.

On the other hand, the exchange rate can vary quite a lot, even from one day to the next. This can create uncertainty and discourage people from trading and investing. It can also worsen economic problems, especially if the currency’s value goes down at a time when prices are going up.

Advantages and disadvantages of a fixed exchange rate


The main (and obvious) advantage of a fixed exchange rate is stability.

Pegging to a stronger currency (or a basket of them) means you don’t have to worry about daily changes in your level of income or the value of your investments. This encourages international trade and foreign investment, which helps the economy grow and the standard of living to improve.

Of course, the currencies of countries with strong economies tend to fluctuate much less than the currencies of developing countries. Unsurprisingly, fixed exchange rates tend to be popular with developing countries.

Unfortunately, keeping a fixed exchange rate is hard work. Countries need to constantly monitor the market and take action to prevent economic changes from affecting their exchange rate.

More often than not, this involves buying and selling currency to influence supply and demand, which requires huge reserves of cash. If these reserves run out, countries with fixed exchange rates could be in for an economic crisis.

https://transferwise.com/us/blog/fixed-floating-exchange-rate-difference

Excellent article.  Thanks, Nash.