A floating exchange rate is known as an administration where the forex market based on supply and demand relative to other currencies sets the currency price of a nation. On the other hand, the fixed exchange rate is where the government entirely or predominantly determines the rate.
How It Works
Floating exchange rate systems indicate long-term currency price changes mirror relative economic strength and interest rate differentials between countries.
Then, short-term moves in a floating exchange rate currency reflect disasters, speculation, rumors, and everyday supply and demand for the currency. In case the supply outstrips demand, then the currency will fail, and demand exceeds supply, then the currency will rise.
Also, extreme short-term moves can lead to intervention by central banks, even in a floating rate environment. As a result, while a lot of major global currencies are considered floating, central banks and governments might step in if a nation’s currency went too high or too low.
If a currency is too high or too low, it will end up affecting the nation’s economy negatively, involving trade and the ability to pay debts. The government or central banks will try to impose measures to move their currency to a more suitable price.
What About Fixed Exchange Rates?
Currency prices differ in two ways, a floating rate, and a fixed rate. As explained earlier, the floating rate is typically determined by the open market via supply and demand. Thus, if the demand for the currency is high, the value will increase. But if the demand is low, this will make the currency price lower.
Through the central bank of the government, they can determine a fixed or pegged rate. They set the rate against another major world currency, like the U.S. dollar, euro, or yen. And to keep its exchange rate, the government will purchase and sell its own currency against the currency to which it is pegged. China and Saudi Arabia are some of the countries that chose to peg their currencies to the U.S. dollar.
Aside from that, a fixed exchange rate tells traders that they can always exchange the money in one currency for a similar amount of another. It lets them know how much one currency a person can trade for another currency.
For instance, in Saudi Arabia, a dollar will buy 3.75 Saudi riyals. and this is because of the fixed exchange rate of the dollar. Now, Saudi Arabia did that due to its primary export, oil – which is priced in U.S. dollars.
