Is it better to have Pegged or Floating Forex Rates?

Open economies in a worldwide market are faced with three


aims:

1.     


Stabilizing the forex rate

2.     


Enjoying international


capital mobility

3.     


Using a monetary policy tailored


for domestic goals

Unfortunately, attractive as these


goals are, they're paradoxical.


Pegged forex rates


stabilize the forex rate while engaging


in domestically-oriented monetary policy. But, pegged rates don't coincide with enjoying world capital


mobility, which is where floating foreign exchange rates come


in.

Pegged forex rates

A pegged


foreign exchange rate is when a currency's


price is pegged to the value of another currency, group of


currencies, or another asset, like gold. Fixed exchange rates were used globally from 1944


to 1973, but now fixed exchange rates


are mainly employed by small


countries with economies that are essentially


dependent on foreign partners.

 Fixed


exchange rates are


infrequently evaluated for political


and business reasons, either being revaluated or


devaluated. A devaluation in a fixed exchange rate lowers


the value of the fixed currency, making exports more


attractive to foreign investors as they become cheaper when their value is converted into the investors'


currencies. This also discourages imports as imported goods


get more expensive due to the foreign exchange rate, the final


target being to increase trade surpluses while decreasing trade


deficits.

A revaluation raises


the value of the fixed currency, causing the opposite scenario to


happen.

Floating foreign-exchange rates

Floating forex rates are when a currency's price


changes dependent on factors in the currency market , such as the currency's


economy, financier sentiment, politics, inflation and interest


rate derivatives.

This is the most


common regime for major economies with two


alternatives: free floating currencies and managed


floating currencies.

The value of free


floating currencies is solely decided by currency market forces and can change


greatly, providing opportunities for traders to


profit on rising and falling currency values.

Managed floating


currencies are able to float to a certain amount, and will be reined in by the central bank if


it travels too far away from ideal levels.

That being said, each floating exchange rate is managed, at least a bit. If a currency goes too far off course, that country's


central bank will reply by changing IRs or by


buying and selling big


amounts of currency to bring its currency back to


acceptable levels.

Fixed versus. Floating foreign


exchange rates

Fixed


exchange rates benefit from reduced risks in


global trade and investment as


global buyers and sellers can


agree to a fee that won't be exposed


to foreign exchange rate changes. Fixed


exchange rates can introduce stricter


business management, keeping inflation in order, and they can also reduce speculation, which can often be destabilising to less-established economies.

However, the


disadvantages of fixed exchange rates are that there is no automated


balance of payments between countries without government


interference ; big holdings of foreign exchange reserves are


critical to maintain the fixed rate ; the


necessity to maintain the exchange rate can dominate


financial policy, that may be better


concentrated on other things ; and


fixed exchange rates can be unstable,


leading to different rates of inflation causing imbalances


of the levels of competitiveness between


different countries.

Countries with


floating exchange rates benefit from


allowing the market to quickly respond to


commercial events, as opposed


to waiting for the central bank's reaction. As the currency market is open 24-hours a day, free floating currencies can


react extremely fast to important


news. This also ends in automated


correction in balance of payments adjustments as the currency rates


adapt to balance demand and supply.

As this


can be looked after


automatically, governments should have more time to


commit policy to other matters.

As floating rates


change automatically, they do not suffer


from international relations crises that can plague


countries with fixed foreign exchange


rates when pressure mounts on a currency to devalue or revalue.

And


countries with floating exchange rates can


have lower foreign exchange reserves.

However,


floating exchange rates result in


instability and doubt when it comes down to global trade, as fluctuations


can lead to changing costs for imports


and exports. This doubt can also lead directly to a


dearth of foreign investment. Having mentioned that, this risk can be hedged by trading with forward transactions.

Floating foreign exchange rates may lead to


unruly economic management as inflation isn't


punished, and governments may follow inflationary economic policies.

Nonetheless


the drawback of this is that severe shocks


may cause a currency to plunge, magnifying the economic


damage. And, as speculation is higher in floating exchange rate systems,


there's more uncertainty for forex traderes and investors. A floating exchange rate may also cause inflation by permitting import prices


to rise as the exchange rate falls.     









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