Currency Exchange – Understanding Floating Rate vs. Fixed Rate
Published on May 20th, 2015 | by Joan Makai
Trading has come a long way from the days of barter system. Now, there are currencies used to buy or sell goods. No country in the world is secluded anymore. Therefore, the trade goes on across the borders as well. Since different countries have different currencies, it is necessary to have a measure for valuing these currencies with respect to one another.
Gold became the accepted standard at one time, and each currency was valued against it. Therefore, the value of each such currency had a “fixed rate” which represented how much of such currency was needed to buy one ounce of gold. Subsequently, the US dollar replaced gold as the measurement standard for valuing any currency. In turn, the dollar was valued vis-à-vis one ounce of gold.
But the method was not satisfactory because the price of gold keeps on increasing, and the economies of countries also keep on changing. Therefore, floating rate system or floating exchange rate was evolved. Some countries adopt floating rate method for exchanging their currency, whereas others prefer fixed rate method. Also to these, there is a managed floating method as well, which is a hybrid of fixed and floating rates.
Floating Rate vs. Fixed Rate
In floating exchange rate, the value of the currency keeps on varying as per demand and supply of that currency in the international market. Therefore, international economic environment affects the value of the currency, and in turn, the economic conditions within the country. Theoretically, the central bank assesses the total value of assets with it, such as gold and forex in dollar terms. After that, this money in dollar terms is equated to the country’s currency in circulation and balance printed currency. Effectively, the value of one dollar is obtained by this method at that point of time. Since the dollar value keeps on varying due to demand and supply in the international market, the country’s currency value too keeps on floating.
In this scenario, Central Banks of countries with floating exchange rates may not be able to control the value externally. However, they can use monetary policies within the country to foster demand, thereby increasing both employment and output. Such policies, in turn, are useful in preventing excessive loss in value of the currency in forex markets. Therefore, the business cycle is completed.
Unlike this, in the fixed exchange rate regime, the value of the currency is fixed with respect to individual currencies or a single currency. Therefore, the central bank of the country is forced to purchase or sell dollars periodically to keep the value of the country’s currency at the fixed rate. The advantage of this method is that there is no excessive fluctuation. But in recessionary times, there is not much room to revive the economy with some monetary policies.
Both systems of exchange rate determination have their advantages and disadvantages. In fact, neither of the two systems is good as a perpetual method because floating exchange rate is good in some economic conditions, whereas fixed exchange rate is good in other economic conditions. This is the reason most of the Central Banks nowadays opt for managed rates in which both these methods are used to establish exchange rates for any currency.