Fixed vs floating exchange rates – what’s the difference?

na-ryan-thaxton-stonex-financial-writer-125x125
By : ,  Financial Writer

Fixed vs. floating exchange rates

A fixed exchange rate is when a country pegs its currency’s value to a more stable, influential currency or basket of currencies. In contrast, a floating exchange rate allows a currency’s value to be determined in the foreign exchange market, constantly changing with the supply and demand of the currency.  To see how they compare, let’s go into more detail on both.

What is a floating exchange rate?

A floating exchange rate allows a currency to rise and fall with the demand for a country’s labour, capital, and currency. Because the market dictates it, it is believed to be “self-correcting.”

For example, if the demand for a currency is low, the cost of imports will rise, and residents of that country will turn to locally produced goods and services instead. This will stimulate the local economy, raise the currency’s value and eventually restore the currency’s exchange rate.

When a floating exchange rate fails to self-correct, central banks can intervene by buying and selling significant amounts of their local currency to influence the exchange rate manually. Along with central banks, this buying and selling of currency on floating exchange rates is what you participate in when trading forex.

Examples of floating exchange rates

Most modern economies have floating exchange rates because their imports, exports, and domestic trades are robust enough to maintain a healthy economy. The US dollar, euro, Japanese yen, pound sterling, and Australian dollar all function on a floating exchange.

The effects of floating exchange rates can be seen in any forex market, where the euro may be equal to 1.2 US dollars one month and only 1 US dollar the next.  

You can trade floating exchange rates with City Index. Open a demo account to practise trading major currencies like the euro, British pound, Japanese yen, and US dollar. Practise taking positions on whether exchange rates will rise or fall in the future or learn more in our education series.

What is a fixed exchange rate?

A fixed exchange rate is a regime established by a country to tie their currency to a more influential marker, typically a major currency such as the US dollar or euro. That country’s central bank will then buy and sell its currency against the pegged currency to maintain a consistent exchange rate and keep its currency valued within a narrow price range.

Central banks maintain a fixed exchange rate with a foreign reserve by releasing extra funds into the market in times of inflation or holding back funds during deflation, matching the fluctuating value of their currency peg. A large foreign reserve of the pegged currency is required to do this.

Examples of countries with fixed exchange rates

  1. Some island nations in the Caribbean – including Aruba and Barbados – peg their currencies to the US dollar because their main source of revenue is tourism paid in US dollars. Fixing their currency to the US dollar helps stabilize their small economies and avoid volatility
  2. Meanwhile, Morocco pegs its currency, the dirham, to a basket made up of the euro and US Dollar. The dirham is weighted 60% to the euro and 40% to the Dollar and otherwise functions as any other pegged currency. By pegging the dirham to two currencies, Morocco can better react to both economic prosperity and downturns in Europe and North America

The Swiss franc: A currency peg gone wrong

Switching from one exchange regime to another can be tricky. A recent example involves Switzerland switching to a pegged system and back again within just a few years as they attempted to compete economically with the fluctuating euro and US dollar.

After the European Debt Crisis, many eurozone countries moved their assets from euros to the Swiss franc because of the small nation’s economic stability. Ironically, this massive investment into the franc caused its value to skyrocket, and with it the price of exports and service providers from Switzerland. To reverse this rapid inflation, Switzerland pegged the franc to the euro at 1.20 in September 2011, and the Swiss economy began to settle back down.

However, in January 2015 the nation abruptly unpegged the franc, which quickly appreciated 20% against the euro. Swiss exporters and service providers once again struggled to deliver profits, yet Swiss authorities justified the sudden move by claiming the nation’s economy was stronger than it was four years previously. The franc has since stabilized to around 1.10 against the euro, as the Swiss national bank predicted.

Swiss authorities never officially stated their reasoning for the unpegging, but common theories involve speculation that Switzerland wanted to detach itself from the euro to assuage fears of American investors as the euro began weakening against the US dollar.

Is a fixed or floating exchange rate better?

In both floating and fixed exchange regimes, central banks seek to maintain the currency value that best promotes international trade and a robust economy. Fixed exchange rates are typically used in developing countries to help establish regular trade relationships and grow local economies. Meanwhile, floating exchanges are found in nations whose currency values can be safely maintained by their already established economies.

Some countries have used a fixed exchange rate in periods of severe economic instability while working to establish an economy that can thrive under a floating exchange. However, most countries adopted a floating exchange rate after the fall of the gold standard and the Bretton Woods system.

The Bretton Woods Agreement

Foreign currency exchanges were first established in July 1944 by delegates of 44 countries in the Bretton Woods Agreement. Under this new system, the US dollar was pegged to gold at $35 an ounce, and all other currencies were pegged within 1% to the dollar.

The original fixed exchange system established by in Bretton Woods Agreement only lasted a few decades. Then, in the early 1970s, the US announced gold would no longer be exchanged for dollars and floating exchanges took the place of the once-fixed system. Since then dozens of countries – including Russia, South Africa, and Switzerland – have switched between fixed and floating exchange regimes depending on the needs of their economies.

The World Bank and International Monetary Fund were also established at the agreement, two institutions that still support international economies today and foster global cooperation among 189 member countries.

Trade floating exchange rates on the forex market

The forex market established through floating exchange rates is the largest and most liquid market in the world with over $6.6 trillion in daily trading volume according to the 2019 Triennial Central Bank Survey. You can open an account with City Index to start trading now or learn more about trading with our educational series.

Please be aware that Forex Trading involves significant risk of loss and is not suitable for all investors

 

Related tags: Insights monetary policy

Open an account today

Experience award-winning platforms with fast and secure execution.

Web Trader platform

Our sophisticated web-based platform is packed with features.

Economic Calendar