Fixed versus Floating Exchange Rates
The foreign currency exchange, or Forex market, is based on the fact that the value of the various currencies around the world is not equal. This means that what can be bought with one unit of currency may cost several units of another currency. The restricted use of foreign currencies in local markets requires that one currency be used to purchase another when travelling or conducting business in a foreign country, which is called currency exchange. However, the value of many foreign currencies is partially determined by supply and demand, which causes their value in relation to other currencies to fluctuate. This fluctuation makes it possible to trade currencies strictly for investment purposes, in the hope that the new currency will grow in value more than the previous currency.
World currencies all have an exchange rate in relation to each other, but that rate is in one of two forms: fixed or floating. Each form works very differently from the other.
Fixed Exchange Rates
A fixed exchange rate is one that is determined strictly by the exchange rate of another currency to which it is linked, or pegged. In a pegged rate, the central bank, the authority responsible for governing a nation’s foreign exchange and monetary policy, fixes the exchange rate to that of another currency. The peg does not have to be even, or on par. The peg can be any ratio that the central bank deems fit. Most currencies with a fixed exchange rate are pegged to the U.S. dollar, but some are pegged to the Euro or another of the world's major currencies.
The value of a pegged currency does not fluctuate on the open market against the peg currency, and it only fluctuates with other currencies in so much as the peg currency fluctuates. In order to maintain the local value of the currency, the central bank buys or sells volumes of the peg currency, which make up the nation's foreign reserves.
Floating Exchange Rates
The value of a currency with a floating exchange rate is determined by supply and demand on the foreign currency exchange, or Forex. The Forex is the largest market in the world, and it operates 24 hours per day. Some economists have called floating currencies self-correcting currencies because the market corrects the differences in supply and demand. This happens because when demand for a currency is low, value decreases. When the value decreases, demand for local goods and services are stimulated because they cost less than imported goods and services. This increase in local demand generates jobs and causes the currency to rise in value again.
From a market perspective, floating currencies can be called self-correcting because when value is low, traders buy more of the currency. As traders buy more of the currency, supply runs low and demand increases. This causes the currency to rise in value, which, in turn, causes traders to sell the currency, increasing supply and lowering demand.
Theory versus Reality
In reality, the value of a currency is never strictly tied to another. In theory and on the books, the value may be fixed, but market demands and real-world supply does not cease to exist. When a currency loses its local value against a pegged currency, the central bank restricts trading, which causes a black market to emerge. The value of the currency on the black market is much closer to the currency's true value, irrespective of the official exchange rate set forth by the central bank.
On the other hand, the value of a floating currency is never wholly determined by supply and demand on a free market. Central banks of floating currencies fix the market when value fluctuates out of favor by adding or removing supplies of currency from the market. When demand needs to be increased, the central bank sells securities, thus removing currency from the market and decreasing the supply. When demand needs to be decreased, the central bank buys back the securities it sold previously, adding to the supply of currency on the market and decreasing its value.
History of Currency Pegging
Historically currency has always been pegged, although not to other currencies. Currency was pegged to precious metals: gold, silver or both. Countries would take their currencies off the precious metal standard and float them for stretches of time, but they would eventually return. After the economic instability created by World War II, many currencies of the world became pegged to the U.S. dollar to ensure stability. The dollar, in turn, was still on the gold standard. In 1971, the dollar was removed from the gold standard and floated. This provided an opportunity for other currencies to float, and the modern foreign currency exchange was born.
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