Floating Rate Vs. Fixed Rate

More than $3 trillion is traded in the currency markets on a daily basis, as of 2011. So 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. If you are traveling to India, for example, and the exchange rate for U.S. dollars is 1:51.2 for Indian Rupees, this means that for every U.S. dollar, you can buy 51.2 Indian Rupees. 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. There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government sets and maintains as the official exchange rate. A set price will be determined against a major world currency. 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.

Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. 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” 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. In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation. 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. Nevertheless, with the start of World War I, the gold standard was abandoned.

At the conclusion 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. This lead to the establishment of an international monetary system embodied in the International Monetary Fund (IMF) to promote foreign trade and to maintain the monetary stability of countries. It was agreed that currencies would once again be fixed, but this time to the U.S. dollar, which in turn was pegged to gold at US$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 Canadian dollars, the value of the dollars would be expressed in U.S. dollars, whose value in turn was determined in the value of gold. The peg was maintained until 1971, when the U.S. dollar could no longer hold the value of the pegged rate of US$35 per ounce of gold. The major governments adopted a floating system, and all attempts to move back to a global peg were eventually abandoned in 1985. The reasons to peg a currency are linked to stability. 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” peg, whereby the government reassesses the value of the peg periodically and then changes the peg rate accordingly. Usually, this causes devaluation. This method is often used in the transition from a peg to a floating regime. 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 lasting value of a currency and creating equilibrium in the international market.