A fixed exchange rate regime should be viewed as a tool in capital control. Typically a government maintains a fixed exchange rate by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market using its reserves.
This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the government sells its own currency, thus increasing its foreign reserves.
Another, method of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This method is rarely used because it is difficult to enforce and often leads to a black market in foreign currency. Some countries, such as China in the s, are highly successful at using this method due to government monopolies over all money conversion.
China used this method against the U. PRC Flag : China is well-known for its fixed exchange rate. It was one of the few countries that could impose a fixed rate by making it illegal to trade its currency at any other rate.
Managed float regimes are where exchange rates fluctuate, but central banks attempt to influence the exchange rates by buying and selling currencies. Almost all currencies are managed since central banks or governments intervene to influence the value of their currencies.
So when a country claims to have a floating currency, it most likely exists as a managed float. India : India has a managed float exchange regime. The rupee is allowed to fluctuate with the market within a set range before the central bank will intervene.
Management by the central bank generally takes the form of buying or selling large lots of its currency in order to provide price support or resistance. For example, if a currency is valued above its range, the central bank will sell some of its currency it has in reserve.
Some economists believe that in most circumstances floating exchange rates are preferable to fixed exchange rates. Floating exchange rates automatically adjust to economic circumstances and allow a country to dampen the impact of shocks and foreign business cycles. This ultimately preempts the possibility of having a balance of payments crisis.
However, pure floating exchange rates pose some threats. A floating exchange rate is not as stable as a fixed exchange rate. If a currency floats, there could be rapid appreciation or depreciation of value. This is why a managed float is so appealing. A country can obtain the benefits of a free floating system but still has the option to intervene and minimize the risks associated with a free floating currency.
Privacy Policy. Skip to main content. Open Economy Macroeconomics. Search for:. Exchange Rates. Introducing Exchange Rates In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. Learning Objectives Explain the concept of a foreign exchange market and an exchange rate.
Key Takeaways Key Points Exchange rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers where currency trading is continuous. Key Terms exchange rate : The amount of one currency that a person or institution defines as equivalent to another when either buying or selling it at any particular moment.
Finding an Equilibrium Exchange Rate There are two methods to find the equilibrium exchange rate between currencies; the balance of payment method and the asset market model. Key Takeaways Key Points The balance of payment model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance.
The balance of payments model focuses largely on tradeable goods and services, ignoring the increasing role of global capital flows. This includes financial assets. Key Terms depreciate : To reduce in value over time. Real Versus Nominal Rates Real exchange rates are nominal rates adjusted for differences in price levels. Learning Objectives Calculate the nominal and real exchange rates for a set of currencies. Changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy.
To calculate the nominal exchange rate, simply measure how much of one currency is necessary to acquire one unit of another. Key Terms real exchange rate : The purchasing power of a currency relative to another at current exchange rates and prices.
Exchange Rate Policy Choices A government should consider its economic standing, trade balance, and how it wants to use its policy tools when choosing an exchange rate regime. Learning Objectives Explain the factors countries consider when choosing an exchange rate policy.
Key Takeaways Key Points A free floating exchange rate increases foreign exchange volatility, which can be a significant issue for developing economies since most of their liabilities are denominated in other currencies. Floating exchange rates automatically adjust to trade imbalances while fixed rates do not. Some governments may choose to have a "floating," or " crawling " peg, whereby the government reassesses the value of the peg periodically and then changes the peg rate accordingly.
Usually, this causes devaluation, but it is controlled to avoid market panic. This method is often used in the transition from a peg to a floating regime, and it allows the government to "save face" by not being forced to devalue in an uncontrollable crisis. Although the peg has worked in creating global trade and monetary stability, it was used only at a time when all the major economies were a part of it.
While a floating regime is not without its flaws, it has proven to be a more efficient means of determining the long-term value of a currency and creating equilibrium in the international market. Your Privacy Rights. To change or withdraw your consent choices for Investopedia.
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Personal Finance. Your Practice. Popular Courses. Part Of. Global Players. Economy Economics. Table of Contents Expand. Floating Rate vs. Fixed Rate: An Overview. Fixed Rates. Floating Rates. Special Considerations. Variations on Fixed Rates. Key Takeaways A floating exchange rate is determined by the private market through supply and demand. A fixed, or pegged, rate is a rate the government central bank sets and maintains as the official exchange rate.
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Partner Links. Most major industrialised nations have floating exchange-rate systems, where the foreign exchange market forex prices decide their currency price. For these nations, this practice began in the early s, while developing economies continued with fixed-rate systems. Developing economies commonly use a fixed rate structure to curb inflation and provide a stable system. A secure environment enables importers, exporters, and investors to plan without having to worry about currency movements.
A fixed-rate structure, however, limits the ability of a central bank to change interest rates as required for boosting economic growth. Often, a fixed rate system prevents market fluctuations when a currency is over or undervalued. Effective management of a fixed-rate system also needs a large pool of reserves, when it is under pressure, to support the currency.
An unsustainable official exchange rate can also trigger a parallel, unofficial, or dual exchange rate to grow. A large gap between official and unofficial rates will draw hard currency away from the central bank, which can result in shortages of forex and periodic devaluations.
These can be more detrimental for an economy than the daily adjustment of a floating currency regime. Iran had set a fixed exchange rate of 42, rials to the dollar in , according to BBC News, after losing 8 per cent against the dollar in one day. The government has decided to eliminate the discrepancy between the rate traders used, i.
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