This article covers the details on how forex rates work and what fixed and floating exchange rates are.
A basic method of determining how forex rates work is to consider what you would do if you need to pay for an item to be sent to you from another country. You need to convert your domestic currency to the foreign currency in order to pay for the item. The same applies if you wish to sell an item to someone in another currency. The amount you receive from that person has to be converted to your domestic currency.
Countries depend on their national currency to determine an item’s value regardless of the country it is located in. FX rates are important for trade and the functioning of global countries as not all the countries have the same currency. Forex rates can be determined as the cost one currency to that of another currency.
Floating forex rates are set by the market. A country’s currency is worth what the buyers perceive it to be, based on demand and supply. Supply and demand is motivated by inflation, foreign investment, the ratio of exports and imports and many other economic factors.
Countries with mature, stable economic climates generally use the floating rate system. It is considered to be the more efficient method because the market adjusts the rates automatically by taking account of inflation and other economic determinants. This system is not perfect as a country could lose huge amounts of investment funds if its currency suffers a decline. This decline in forex rates could cause other economic problems for countries.
Pegged or Fixed Forex Rates
Countries that adopt this system fix their rates at a certain level. The government has to make use of artificial methods to maintain the pegged rate. The rate is often fixed to that of another country’s currency and will generally not experience much movement from one day to another.
Governments do not have an easy task on their hands when they opt for this system. The central bank has to maintain a high level of reserves of foreign currencies to absorb the supply and demand of their currency. If there is a sudden demand for their currency, the central bank has to ensure that they have sufficient funds to meet the demand. If the demand for the currency takes a sudden dive, the central bank of that country would have to buy back their currency.
This system is favoured by countries with immature economies and unstable countries. Developing countries favour this system as it allows them to maintain a level of inflation that they can control. This is an extremely risky system as the country could reach a point when their pegged rate is no longer in line with what their currency is really worth. If they were to adjust their fixed rate to the actual rate, it could send the country into an economic downtrend. This may push up the inflation rate and cause the currency to decline even further. The government of the country would have to adjust the value of its currency over a period of time to avoid an economic meltdown.
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