Variable rate vs fixed rate: an overview
Over $ 5,000 billion is traded daily in the forex markets, a huge amount by any means. All of this volume is traded around an exchange rate, the rate at which one currency can be exchanged for another. In other words, it is the value of another country’s currency against yours. If you are traveling to another country, you must “buy” the local currency. Just like the price of any asset, the exchange rate is the price at which you can buy that currency.
If you travel to Egypt, for example, and the exchange rate for US dollars is 1: 5.5 Egyptian pounds, that means for every US dollar you can buy five and a half Egyptian pounds. Theoretically, identical assets should sell for the same price in different countries, as the exchange rate must maintain the intrinsic value of one currency against another.
Key points to remember
- A floating exchange rate is determined by the private market through supply and demand.
- A fixed or indexed rate is a rate that the government (central bank) fixes and maintains as the official exchange rate.
- The reasons for anchoring a currency are linked to stability. Especially in developing countries today, a country may decide to tie its currency to create a stable atmosphere for foreign investment.
A fixed or indexed rate is a rate that the government (central bank) fixes and maintains as the official exchange rate. A fixed price will be determined against a major world currency (usually the US dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in exchange for the currency to which it is pegged.
If, for example, it is determined that the value of a single unit of local currency is equal to $ 3, the central bank will need to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must maintain a high level of foreign exchange reserves. This is a reserved amount of foreign currency held by the central bank that it can use to release (or absorb) additional funds in (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation / deflation) and, ultimately, the exchange rate. The central bank can also adjust the official exchange rate if necessary.
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often referred to as âauto-correctingâ because any difference between supply and demand will automatically be corrected in the market. Look at this simplified model: if demand for a currency is low, its value will decrease, making imported goods more expensive and stimulating demand for local goods and services. This, in turn, will generate more jobs, causing self-correction in the market. A floating exchange rate is constantly changing.
In reality, no currency is entirely 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” (which more closely reflects actual supply and demand) can develop. A central bank will then often be forced to revalue or devalue the official rate so that the rate is in line with the unofficial rate, thus halting black market activity.
In a floating regime, the central bank can also intervene when it is necessary to ensure stability and avoid inflation. However, the central bank of a floating regime will intervene less often.
Between 1870 and 1914, there was a fixed world exchange rate. Currencies were pegged to gold, which meant that the value of the local currency was set at a fixed exchange rate to the ounce of gold. It was called the gold standard. This allowed unlimited capital mobility as well as global currency and trade stability. However, with the start of World War I, the gold standard was abandoned.
At the end of World War II, the Bretton Woods Conference, an effort to generate global economic stability and increase world trade, established the basic rules and regulations governing international trade. As such, an international monetary system, embodied in the International Monetary Fund (IMF), was set up to promote foreign trade and maintain the monetary stability of countries and, consequently, that of the world economy.
It was agreed that the currencies would again be pegged, or pegged, but this time to the US dollar, which in turn was pegged to gold at $ 35 an ounce. This meant that the value of a currency was directly related to the value of the US dollar. So, if you were to buy Japanese yen, the value of the yen would be expressed in US dollars, the value of which, in turn, was determined by the value of gold. If a country needed to readjust the value of its currency, it could turn to the IMF to adjust the fixed value of its currency. The anchor was maintained until 1971, when the US dollar could no longer hold the value of the anchor rate of $ 35 per ounce of gold.
From then on, major governments adopted a floating system and all attempts to return to a global anchor were finally abandoned in 1985. Since then no major economy has returned to a anchor, and the use of gold as an anchor has been completely abandoned.
The reasons for anchoring a currency are linked to stability. Especially in developing countries today, a country may decide to tie its currency to create a stable atmosphere for foreign investment. With an anchor, the investor will always know how much his investment is worth and will not have to worry about daily fluctuations.
An indexed currency can help reduce inflation rates and generate demand, resulting in greater confidence in the stability of the currency.
Fixed diets, however, can often lead to serious financial crises, as a peg is difficult to maintain over the long term. This was observed during the Mexican (1995), Asian (1997) and Russian (1997) financial crises, where an attempt to maintain a high value of the local currency at the anchor resulted in an overvaluation of currencies. This meant that governments could no longer meet demands to convert local currency into foreign currency at the fixed rate.
With speculation and panic, investors rushed to get their money out and convert it into foreign currency before the local currency was devalued against the peg; foreign exchange reserves eventually ran out. In the case of Mexico, the government was forced to devalue the peso by 30%. In Thailand, the government eventually had to let the currency float, and by the end of 1997 the Thai bhat had lost 60% of its value due to market demand, and the supply readjusted the value of the local currency. .
Hard-pegged countries are often associated with unsophisticated capital markets and weak regulatory institutions. The ankle is there to help create stability in such an environment. You need a stronger system and a mature market to keep it floating. When a country is forced to devalue its currency, it is also required to undertake some form of economic reform, such as implementing greater transparency, with the aim of strengthening its financial institutions.
Variations on fixed rates
Some governments may choose to have a âfloatingâ or âcreepingâ peg, whereby the government periodically reassesses the value of the anchor and then changes the anchor rate accordingly. Usually this causes devaluation, but it is controlled to avoid market panic. This method is often used in the transition from a fixed regime to a floating regime, and it allows the government to “save face” by not being forced to devalue in the event of an uncontrollable crisis.
Although the peg worked in creating world trade and monetary stability, it was only used at a time when all major economies were part of it. While a floating regime is not without its flaws, it has proven to be a more efficient way to determine the long-term value of a currency and to create equilibrium in the international market.