In Forex different participants trade currencies, buying and selling in order to profit from changes in the exchange rate. In this article we will see what is the exchange rate, different systems (fixed exchange rate and flexible exchange rate) and why some exchange rates fluctuate and are traded on the Forex market and others not.
What is the exchange rate?
The exchange rate is the rate at which a currency can be exchanged for another. In other words, it is the value of the currency of one country compared to the currency of another country. If we travel to a foreign country, we need to “buy” the local currency. Like the price of any asset, the exchange rate is the price at which you can buy that currency. If you are traveling to Egypt, for example, and the exchange rate for US dollars is 1: 5.5 Egyptian pounds, this means that for every USD you can buy five and a half Egyptian pounds. Theoretically, identical assets should sell at the same price in different countries, because the exchange rate must maintain the intrinsic value of one currency against another.
Fixed exchange rate
There are two ways in which the price of a particular currency relative to another can be established. A fixed exchange rate is the rate at which the government (central bank) establishes and maintains the official exchange rate. A fixed price will be determined in relation to a major world currency (usually the US dollar or other major currencies such as the euro, yen or a basket of currencies). In order to maintain the local exchange rate, the Central Bank buys and sells its own currency in the foreign exchange market in exchange for the currency to which it is linked.If, for example, it is determined that the value of a unit of local currency is equal to $3, the central bank will have to ensure that they can supply the market with those dollars.
Therefore, in order to maintain the exchange rate, the central bank should maintain a high level of international reserves. This is an amount of foreign currency held by the central bank which is reserved for release (or absorb) extra funds into (or from) the market. This ensures an adequate money supply, stabilize the fluctuations of the market (inflation/deflation), and ultimately the exchange rate. The central bank can also adjust the official exchange rate when necessary.
Flexible exchange rate
Unlike the fixed exchange rate, a floating exchange rate is determined by the private market through supply and demand. A floating exchange rate is often called “self-corrective”, since differences in supply and demand will automatically be corrected in the market. We can understand this by the following simplified model: if demand for a currency is low, its value decreases, so that imported goods are more expensive and demand for local goods and services is stimulated. This, in turn, will generate more jobs, resulting in a self-correction in the market. A flexible exchange rate is constantly changing.
Actually, there are no currencies with a completely fixed or flexible exchange. In a fixed regime, market pressures can also influence the exchange rate, though not automatically, and the corresponding Central Bank will decide when and which exchange rate variation will perform. Sometimes, when the value of a fixed currency does not reflect the real value against the currency to which it is linked, a “black market” is created which in most cases reflects the actual supply and demand. A central bank often will be forced to revalue or devalue the official exchange rate in order that their interest rates are in line with the official exchange rate, stopping the black market activity.
Under a flexible exchange rate, the central bank may also intervene when necessary to ensure stability and, above all, to prevent rising inflation, however, the intervention of a central bank with a flexible exchange rate system type is less frequent.
Why the fixed exchange rate?
The reasons that lead to choosing a fixed exchange rate are related to stability. Especially in developing countries, the authorities can decide to have a fixed currency to create a stable environment for foreign investment. With a fixed exchange rate, the investor will always know what is the value of their investment, so you do not have to worry about the daily fluctuations of foreign exchange (see foreign currency and exchange risk effect). A fixed currency may also help lower inflation rates and generate more demand, resulting from the increased confidence in the stability of the currency.
The fixed exchange rate systems, however, can often lead to a severe financial crisis since a fixed exchange rate is difficult to maintain in the long-term. This was seen in the Mexican financial crisis in 1995, Asia (1997) and Russia (1997), when an attempt to maintain a high value of the currency resulted in a high overvaluation. This caused that governments could no longer meet the demands to convert the local currency to foreign currency at the fixed exchange rate. With speculation and panic, investors rushed to pull their money out of the country and turn it into foreign currency before the local currency was devalued against the currency to which it was attached, and finally the supplies from Central Bank reserves they were exhausted. In the case of Mexico, the government was forced to devalue the peso by 30%. In Thailand, the government finally had to accept a flexible exchange rate, and by the end of 1997, the Thai baht had lost 50% of its demand in the market.
Although the fixed exchange rate system has favored the expansion of world trade and monetary stability, it was used only momentarily by all major economies. Although a flexible exchange rate system is not without its flaws, it has proven more effective in determining the long term value of a currency and create a balance in the international market environment.
The fixed exchange rate in the international arena
Between 1870 and 1914, there was a fixed exchange system at large scale. The value of currencies was tied to gold, the value of currencies was fixed at an exchange rate established in ounces of gold. This is known as the gold standard. This allowed the free movement of capital and the stability of global currencies and encouraged international trade, however, with the onset of World War I, the gold standard was abandoned.
At the end of World War II, the Bretton Woods conference in an effort to achieve global economic stability loss and an increase in world trade established the basic rules and regulations that govern the international monetary exchange. The IMF (International Monetary Fund) and an international monetary system were created to boost foreign trade, maintain the stability of the currencies of the different countries and, therefore, the global economy.
In Bretton Woods was agreed that currencies would again have a fixed exchange rate, but this time with the US dollar, which in turn was pegged to gold at the rate of $35 per ounce. Thus the value of currencies could be expressed directly in US dollars. If a country needed to readjust the value of its currency, it had to go to the IMF. This situation continued until 1971, the moment at which the US dollar could not continue to maintain a fixed exchange rate against gold.
Since then governments of major economies began adopting a system of flexible exchange rates. In 1985, they abandoned any attempt to re-establish a type of binding global change and the gold standard was completely abandoned too. Today there are still some countries with a fixed exchange rate system, especially colonies and European ex-colonies European and developing countries and emerging economies.