Fixed vs. Floating Exchange Rates
At Interactive FX, we don’t just want to streamline and simplify the process of exchanging and transferring funds internationally—we also want to educate and inform our users as best we can. To that end, in this article we’ll discuss the difference between two terms you may see on the forex market—a “fixed” exchange rate versus a “floating” exchange rate.
The foreign exchange market trades more than $3 trillion USD on a daily basis, and a huge part of that market is the fluctuation of foreign currency values determined against the value of a different currency. There are two primary ways that the price of a currency is set against another.
In a fixed exchange rate, also known as a “pegged” rate, the government (or central bank thereof) is responsible for maintaining the official exchange rate. The value of the local currency is set (or “pegged”) against a more ubiquitous currency, usually the US dollar or euro. To maintain the exchange rate, the central bank must buy and sell its currency on the forex market in return for the currency against which it’s pegged.
For example, if a country determines that the value of one unit of their currency is equal to two US dollars ($2 USD), then their central bank must keep a certain level of foreign-exchange reserves (foreign currency held by the central bank) that it can use to release extra funds into or out of the market, adjusting for inflation (or deflation) and thereby maintaining their exchange rate.
On the other hand, a floating exchange rate is valued by the global market by supply and demand. If demand is high, the value of the currency increases, and vice versa. The market is automatically corrected (the exchange rate fluctuates), which can lead to economic stimulation or, in other cases, stagnation. A floating exchange rate is ever-changing, ebbing and flowing against the supply and demand of the currency.
Most currencies began as either fixed or floating, but these days, it’s rare than any currency is entirely one or the other. Even in a fixed exchange rate, the central bank can revalue the rate to avoid economic turmoil, Conversely, in a floating rate, the government can take measures to avoid inflation by intervening if necessary—though it doesn’t happen often.
While this is a fairly simple explanation, knowing the difference between floating and fixed exchange rates can be useful when watching for fluctuations in currency values and investing wisely in the FX market.