Fixed vs floating exchange rates
Fixed or floating exchange rate
A pegged exchange rate is when a country pegs the value of its currency to a more stable and influential currency or basket of currencies. In contrast, a floating exchange rate helps determine the value of a currency in the foreign exchange market, which is constantly changing with the supply and demand for the currency. To see how they compare, let’s go into more detail on the two.
What is a floating exchange rate?
A floating exchange rate allows a currency to move up and down with a country’s demand for labor, capital, and money. Because the market dictates, it is believed to be “self-correcting”.
For example, if the demand for a currency is low, the cost of imports will increase and residents of that country will turn to locally produced goods and services instead. This will boost the local economy, increase the value of the currency, and eventually restore the currency’s exchange rate.
When a floating exchange rate fails to self-correct, central banks can intervene by buying and selling large amounts of their local currency to manually influence the exchange rate. With central banks, this buying and selling of currencies at floating exchange rates is what you participate in when trading forex.
Examples of floating exchange rates
Most modern economies have floating exchange rates because their imports, exports, and internal trade are robust enough to maintain a healthy economy. The US Dollar, Euro, Japanese Yen, British Pound and Australian Dollar all operate in a floating market.
The effects of floating exchange rates can be seen in any foreign exchange market, where the euro may be equal to 1.2 US dollars one month and only 1 US dollar the next.
You can trade floating exchange rates with FOREX.com. Open a demo account to practice trading major currencies like Euro, British Pound, Japanese Yen and US Dollar. Practice taking a position on rising or falling exchange rates in the future or learn more in our education series.
What is a fixed exchange rate?
A pegged exchange rate is a scheme established by a country to tie its currency to a more influential marker, usually a major currency such as the US dollar or Euro. The central bank of that country will then buy and sell its currency against the pegged currency in order to maintain a constant exchange rate and keep the value of its currency within a narrow price range.
Central banks maintain a fixed exchange rate with a foreign exchange reserve by releasing additional funds to the market during times of inflation or by withholding funds during deflation, corresponding to the fluctuating value of their monetary peg. A large foreign reserve of pegged currency is needed to do this.
Examples of countries with fixed exchange rates
- Some Caribbean island nations – including Aruba and Barbados – peg their currencies to the US dollar because their main source of income is tourism paid in US dollars. Fixing their currency to the US dollar helps stabilize their small economies and avoid volatility
- Meanwhile, Morocco pegs its currency, the dirham, to a basket made up of the euro and the US dollar. The dirham is weighted 60% against the euro and 40% against the dollar and otherwise functions like any other pegged currency. By pegging the dirham to two currencies, Morocco can better respond to both economic prosperity and downturns in Europe and North America.
The Swiss franc: a monetary peg gone wrong
Switching from one trading regime to another can be tricky. A recent example is Switzerland’s move to a peg-and-return system in just a few years as it tried to compete economically with the swings of the Euro and US Dollar.
After the European debt crisis, many countries in the euro zone moved their assets from the euro to the Swiss franc due to the economic stability of the small nation. Ironically, this massive investment in the franc caused its value to skyrocket, and with it the price of Swiss exports and service providers. To reverse this rapid inflation, Switzerland pegged the franc to the euro at 1.20 in September 2011, and the Swiss economy began to calm down.
However, in January 2015, the nation abruptly unpegged the franc, which quickly appreciated by 20% against the euro. Swiss exporters and service providers once again struggled to generate profits, but Swiss authorities justified the sudden move by saying the national economy was stronger than it was four years earlier. The franc has since stabilized around 1.10 against the euro, as predicted by the Swiss National Bank.
Swiss authorities have never officially stated their reasoning for the non-peg, but running theories involve speculation that Switzerland wanted to detach from the euro to allay US investor fears as the euro began to weaken. weaken against the US dollar.
Is a fixed or floating exchange rate better?
In floating and fixed exchange rate regimes, central banks seek to maintain the value of the currency that best promotes international trade and a robust economy. Fixed exchange rates are typically used in developing countries to help establish regular trading relationships and grow local economies. Meanwhile, floating exchanges are found in countries whose monetary values can be safely maintained by their already established economies.
Some countries have used a fixed exchange rate during times of severe economic instability while striving to establish an economy that can thrive on a floating exchange rate. However, most countries adopted a floating exchange rate after the fall of the gold standard and the Bretton Woods system.
The Bretton Woods Agreement
Exchange offices were first established in July 1944 by delegates from 44 countries under the Bretton Woods agreement. Under this new system, the US dollar was pegged to gold at $35 an ounce, and all other currencies were pegged less than 1% to the dollar.
The initial fixed trading system established by the Bretton Woods agreement only lasted a few decades. Then, in the early 1970s, the United States announced that gold would no longer be exchanged for dollars and floating exchanges replaced the once fixed system. Since then, dozens of countries – including Russia, South Africa and Switzerland – have switched between fixed and floating exchange rate regimes depending on the needs of their economies.
The World Bank and the International Monetary Fund were also created during the agreement, two institutions that still today support international economies and promote global cooperation among 189 member countries.
Trade floating exchange rates on the forex market
The foreign exchange market established by floating exchange rates is the largest and most liquid market in the world with over $6.6 trillion in daily trading volume according to the 2019 triennial survey of central banks. You can open an account with FOREX.com to start trading now or learn more about trading with our educational series.
Please note that Forex Trading involves significant risk of loss and is not suitable for all investors