Fixed and floating exchange rate

• Fixed and floating exchange rates are the two main aspects of the exchange rate of different currencies.
• An exchange rate is the amount of one currency exchanged for another, either domestically or internationally.
• A floating exchange rate is based on the dynamics of supply and demand for other currencies.
• A fixed exchange rate is pegged to another currency or a basket of currencies, which maintains stability.

Introduction:

The movements of currency exchange rates against each other are the basis on which the currency trading process is based to achieve profits, but there are currencies that are linked to each other at an almost fixed exchange rate for reasons that will be reviewed in this article, which aims to distinguish the difference between floating and fixed currency exchange rates in addition to reviewing the advantages of each system.

First. The concept of floating exchange rate:

This concept expresses the variable exchange rate of one currency against another, which is the change that occurs based on the factors of supply and demand for the currency.

Since if the demand for a particular currency increases more than its supply in the foreign exchange market, its price will increase, and vice versa.

Reasons for changing currency exchange rates within this system:

The high demand for a currency can be due to many reasons, including those related to its strong economy, the interest rates it offers, or the stability enjoyed by the country of that currency, which are the reasons that drive the value of that currency to rise against others.

While the demand for a particular currency may decrease due to other reasons, such as political instability, high inflation, or high national debt, these reasons represent a motive for the exchange rate of that currency to decline against other currencies that enjoy a better position.

The use of the currency and its weight in global trade also play a major role in determining its strength, as the more it is used in executing commercial transactions, this will mean an increase in demand for it, in a way that enhances its exchange rate.

Pros and cons of the floating exchange rate system:

The floating exchange rate has pros and cons, and the following are the most important pros:

1. Flexibility with economic conditions: Currencies with a floating or variable exchange rate adapt to changing economic conditions and express them in a way that enables traders to achieve profits.

2. Achieving economic goals: Countries can achieve their economic goals as a result of fluctuations in their currency exchange rates. For example, some countries may intervene to weaken the value of their currency to stimulate their exports and thus support their trade balance in a way that stimulates economic growth.

3. Achieving financial independence: A country with a floating exchange rate system can address an economic problem such as inflation or recession through the interest rate that will be reflected in one way or another on the currency exchange rate.

4. Reducing the impact of speculation on currencies: Currencies governed by supply and demand factors can express the will of the market more freely and are stable against being affected by speculation.

5. Low reserve requirements: This system does not require the need to maintain huge reserves of foreign currencies to maintain a specific price.

As for the most prominent disadvantages of this system, they are as follows:

1. Uncertainty: This is related to freedom of movement to a very large extent, which leads to large fluctuations in some currencies.

2. Price volatility: A change in the exchange rate of a currency leads to a change in the prices of available goods and services, specifically imported from abroad.

3. Increasing the burden on those responsible for monitoring exchange rates, in terms of the need for the state to have sufficient mechanisms for internal monitoring and the ability to intervene to protect the currency.

Second. Fixed exchange rate concept:

The fixed exchange rate concept refers to the system implemented by a certain government with the aim of linking the exchange rate of its national currency to a certain currency, or a basket of currencies, in cooperation with its central bank. This system dates back to 1944, specifically when the exchange rates of the countries participating in the Bretton Woods Agreement were fixed at the value of the US dollar, which was fixed at the time at the price of gold at $35 per ounce.

Countries resort to using this concept for many reasons, the most prominent of which are:

1. Maintaining a low inflation rate, as a citizen who owns a currency with a fixed exchange rate will not be significantly affected by changes in export prices of goods and services, as he will not care much about the amount of additional money he needs to buy.

2. Maintaining a low interest rate: Achieving a fixed exchange rate for a low inflation rate contributes to enabling the central bank of this currency to maintain low interest rates.

3. Stimulating trade: A fixed exchange rate for a currency will provide a degree of freedom and comfort for producers and exporters, who will not worry much about changes in exchange rates, recalculating costs, or eroding profit margins.

4. Limiting speculation on the exchange rate of the local currency in a way that ensures relative stability for the country's economy.

Pros and cons of the fixed exchange rate system:

The fixed exchange rate system has many pros and cons as is the case with the fixed price system. The following are the most important pros of the fixed exchange rate system:

1. Avoiding currency fluctuations that the currency may be exposed to as a result of supply and demand factors.

2. Encouraging investment and trade: Stabilizing the exchange rate can encourage companies to deal and invest in the country that has chosen to fix its currency exchange rate, in a way that leads to stimulating trade and investment.

3. Maintaining low inflation: This was explained previously in the reasons that lead countries to choose to fix their currency exchange rate.

As for the disadvantages of this type of exchange rate system, they are as follows:

1. Increased cost to the country: Maintaining a fixed exchange rate may be expensive, because the country that resorts to this type must have sufficient foreign exchange reserves to manage and control the value of its currency.

2. Imbalance in the trade balance, especially if an overvalued exchange rate is set for the currency, which will lead to a current account deficit that will negatively affect the trade balance. 3. Limiting the state’s ability to implement independent monetary policies, while treating economic recession or controlling the volume of economic activity.