Forex Basics: Currency Exchange Rates

02/19/2015 6:00 am EST

Focus: FOREX

Miles Wiseman, contributor to CountingPips.com, explains the difference between fixed and floating exchange rates.

The rate at which different currencies are traded is what is known as the exchange rate. Exchange rates are divided into two types, fixed exchange rates and floating exchange rates.

The floating rate is the price that is driven by the market and 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 the managed floating system.

With the 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 a managed floating system. The exchange rates will usually decrease in value when there is a fall in demand for the currency and will increase when demand rises and 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 prevent the currency from fluctuating further. There are two available methods used when managing 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 revaluation. If there is an increase, it is called devaluation.

If there is devaluation with the fixed rate, it will cause the balance to the current account to rise. When this happens, the price of exportation becomes cheaper for foreigners, and this will discourage importation because it will become very expensive for the consumers inside the country. This will then lead to an increase in the trade surplus or a decrease in the trade deficit. The reverse of this will occur when there is revaluation.

Floating System: Advantages and Disadvantages

It is easy for a country to make a correction on the floating system simply by moving 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 companies open, which is usually affected by the flow of money.

Fixed System: Advantages and Disadvantages

The 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 readily adjustable, as with the floating system.

By Miles Wiseman, contributor, CountingPips.com

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.

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