The rate at which different currencies are traded is what is known as the exchange rates. The exchange rates are divided into two which are the fixed exchange rate and the floating exchange rate.
The floating rate is the price which is driven by the market and it is determined when there is no interference from either the government or the central bank when it comes to the free market forces of demand and supply. The floating exchange rate is further divided into the independent floating system and also the managed floating system. With independent floating system the exchange rate is usually determined if there is a free movement in demand and supply. There are situations when the central bank will manage the fluctuations that are taking place daily and when this happens, this is known as managed floating system. The exchange rates will usually decrease in value when there is a fall in demand for the currency and will raise when demand rises and the supply falls.
With the fixed system it is the government that will come in and try and solve the problem if there is no float of the currency and they will also name the level at which the rates will be exchanged. They will do everything possible in their power to sustain the current rate and also avoid the currency from fluctuating further. There are two available methods that are used when price is applied to the price of the currencies which are pegged and fixed.
With the fixed system, if there is a decrease in the exchange rate it is sometimes referred to as revaluations. If there is an increase it is called devaluations. If there is devaluation with the fixed rate it will cause the balance to the current account to rise. When this happens, it becomes the price of exportation becomes cheaper for foreigners and this will discourage importation because it will become very expensive for the consumers in the country. This will then lead to an increase in the surplus of the trade or a decrease with the trade deficit. The reverse of this will occur when there is revaluation.
The advantages and disadvantages of the floating system are; it is easy for a country to make correction on the floating system simply moving the liberally with the equilibriums of supply and demand. There is lagging from the outside events concerning the economy and its currency as it is not tied to a world of high inflation as with the fixed system. Since there is free movement with demand and supply this acts as an umbrella from other world fluctuations. Since firms cannot predict the future rates it becomes very uncertain to them. The system leaves competition of goods from international company’s open which is usually affected by the flow of money.
The advantages and disadvantages of the fixed system are: fixed system offers an assurance because it is less risky to be involved in any international trade or investments. There is barely any speculation with this system. The system has a contradiction when it comes to having free markets because it is not adjustable quickly unlike the floating
system.
Miles Wiseman is a blogger and a writer who takes particular interest in finance and insurance. He writes about all the interesting things related to forex such as exchange rates for UKforex.