A foreign exchange rate is the rate at which you can exchange the currency of one country for that of another. Most people are aware of foreign exchange when they travel. If you intend travelling overseas, you need to obtain the currency of the country you are visiting as it is not possible to pay for services and goods in another country with your local currency. Investors and traders, on the other hand, are interested in the foreign exchange currency rate for business purposes.
The Fixed Foreign Exchange Rate
Fixed exchange rates are set by the government and maintained as the official rate of exchange. This set value will be determined against one of the major currencies, normally the US dollar, but other major currencies can be used, such as the Yen or Euro. To maintain this domestic rate, the central bank purchases and sells off its local currency on the forex market, to obtain the currency to which it has pegged its rate.
This method of fixing requires the central bank to keep a certain level of the foreign currency in reserve. This must be available for use if the central bank needs to absorb or release the extra funds out of or into the marketplace. This ensures a suitable supply of money, controls inflation or deflation and in the end, control the exchange rate. It is possible for the government to adjust this fixed rate if it deems it necessary.
The Floating Foreign Exchange Rate
The floating rate is determined purely by supply and demand. It is sometimes called a self-correcting rate as the variances in supply and demand will auto-correct the rate. If the demand for a particular currency is low, the currency’s value will decline. This makes the cost of imported goods expensive and the demand for local goods will increase. This will create more jobs and cause the currency to be corrected. This rate changes on a regular basis.
The reality is that no currency is completely floating or pegged. In fixed currency governments, the pressures placed on the market may influence the rate. There are times when a currency begins to show its true value against the fixed amount and this can cause a black market for the currency. This situation will force the central bank to revalue the pegged rate in order to stop the black market trade.
The reasons behind pegging a currency are linked to governmental stability. This is apparent in the developing nations today where a country makes a decision to fix its currency rate in order create stability to stimulate foreign investment. Investors in pegged rate countries have the advantage of knowing exactly what their investment is worth at all times. There is no need to be concerned about fluctuating rates which will have an effect on the return on investment. Pegged rates often aid in lowering inflation and generate demand for the currency. This will usually result in more confidence in the stability of that particular currency.
The downside to a fixed rate is that it may not sustainable for long periods of time. Countries that operate with this method are also often associated with having weak regulatory control and unstable capital markets.