Which is Better For Country, Fixed Exchange Rate or Floating?
When we talk floating exchange rate and fixed exchange rate, which is in our mind is when we deposit to a forex broker. Indeed at the beginning we will be asked whether the capital we deposit will be converted with floating exchange rate or fixed exchange rate. However, this article is not about it. We will discuss a little bit better for the country, floating rate or fixed exchange rate?
We all know that the foreign exchange market (also known as FX or forex) is the largest market in the world, right? In fact, more than $ 3 trillion is traded in the forex market every day. Let’s see first what is the exchange rate?
What Are Rates?
Exchange rate is the rate at which a currency can be exchanged for other currencies. In other words, the value of the currency of another country is compared to the value of your currency (or vice versa). If you are traveling to another country, you are required to use local currency and become a necessary “buy” local currency. Just like asset prices, the exchange rate is the price at which you can buy the currency. If for example you are traveling to England, and the pound sterling rate is 1: 17178 rupiah, this means that for every pound sterling, you can buy it with 17178 rupiah.
Fixed Exchange Rate
There are two ways to determine the price of a currency against another currency. The fixed exchange rate is the value that the government (through the central bank) establishes and maintains / maintains as the official rate. The set rate is determined against the world’s major currencies (usually US dollars). To keep the local exchange rate steady, the central bank actively buys and sells its own currency in the foreign exchange market in exchange for the specified currency.
For example, it is determined that the value of one unit of local currency equals $ 3, the central bank should ensure that the central bank can supply the market with the money. In order to maintain value, the central bank should keep the level of foreign exchange reserves high. This is the amount of foreign exchange reserves held by the central bank that can be used to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, as per the fluctuations in the market (inflation / deflation) and finally, the exchange rate. The central bank can also adjust the official rate when necessary.
Unlike fixed exchange rates, floating rates are determined by the private market through market mechanisms, supply and demand. This floating exchange is often called “self-correcting,” as well as differences in supply and demand are automatically controlled by the market. For example: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This will generate more jobs, causing auto-correction in the market. The floating exchange rate keeps changing.
In fact, the currency is not completely fixed or not completely floating. If persisted, market pressure may also affect exchange rate changes. Sometimes, when the local currency reflects its true value against its fixed currency, a “black market” will appear that may reflect more true supply and demand. The central bank is then forced to re-evaluate or devalue the official rate so that this figure is in line with the unofficial, to stop the black market activity.
If floating, the central bank may also intervene when necessary to ensure stability and to avoid inflation. But in a floating state, central banks rarely intervene. Only if it is necessary.
Then which one is better for the country?
A brief explanation of what the exchange rate is, the floating rate and the fixed exchange rate we have explained in the previous article. Here can be a picture which is better for the country, floating rate or fixed exchange rate?
History of Fixed Exchange Rates
In ancient times, between 1870 and 1914, there was a constant exchange rate exchange. The currency is pegged with the value of gold. This means that the value of the local currency remains at the exchange rate set for gold per unit of ounces. Known as the gold standard. This allows unlimited capital mobility as well as global stability in currency and trade. However, with the start of World War I, the gold standard was abandoned.
At the end of World War II, at a conference at Bretton Woods, there was an effort to generate global economic stability and increase global trade, establishing the basic rules governing international exchange. Thus, the international monetary system, embodied in the International Monetary Fund (IMF), was established to promote foreign trade and to maintain the monetary stability of the country and the global economy.
It was agreed that the currency would have a fixed exchange rate, but only for the US dollar, set against gold at $ 35 per ounce. Means that the value of a currency is directly related to the value of the US dollar. So, if you are going to buy Japanese yen, the value of the yen will be expressed in US dollars, whose value will be determined in the value of gold. If a country has to adjust the value of its currency, the country can approach the IMF to adjust its currency rate determination. The fixed exchange rate was maintained until 1971, when the US dollar could no longer accommodate the value of the $ 35 per ounce gold price.
Use of Fixed Exchange Rate
The reason to peg the currency to a fixed value is related to stability. Especially in developing countries today, they can decide to use fixed currency to create stability of foreign investment. By pegging the exchange rate (fixed), investors can know the value of their investment and they do not have to worry about the daily fluctuations. The pegged currency can also help lower the inflation rate and generate demand, which has an impact on growing confidence in currency stability.
When the exchange rate is applied it is often a severe financial crisis, as the exchange rate remains difficult to maintain in the long term. This is seen in the financial crisis in Mexico (1995), Asia (1997) and Russia (1997). Attempts to maintain high marks on a locally pegged currency result in the currency being overvalued. This means that the government can no longer comply with the demand to convert local currency to foreign currency at the level of its benchmark.
With speculation and panic, investors rushed to get their money and convert it into foreign currency before the local currency was devalued against the benchmark’s value; until the foreign exchange reserves finally run out.
In the case of Mexico, the government was forced to devalue 30 pesos. In Thailand, the government finally had to let their currency floating, and by the end of 1997, Thailand’s bhat lost 50% of its value as market demand and supply adjusted the value of local currency. Indonesia? Most affected.
Countries with a fixed exchange rate system are often associated with having unsophisticated capital markets and weak institutions of authority. When a country is forced to devalue its currency, it must carry out economic reforms, such as implementing greater transparency, in an effort to strengthen financial institutions.
Some governments prefer “floating”. Some others choose a fixed exchange rate “crawling”, where the government will examine the exchange rate regularly and then adjust its benchmark rate. Typically, this causes devaluation, but is controlled to avoid market panic. This method is often used in transition from fixed exchange rates to floating, and allows the government to “save face” by not being forced to devalue in an uncontrollable crisis.