Is it better to have Pegged or Floating Forex Rates?

Open economies in a world market are confronted with three


objectives:

1.     


Stabilising the foreign


exchange rate

2.     


Benefitting fromglobal


capital mobility

3.     


Tailoring financial policy for


domestic needs

Unfortunately, although these goals may


be desirable, they are contradictory.


Fixed foreign exchange rates


stabilise the foreign exchange rate while engaging


in domestically-oriented financial policy. That being


said, fixed foreign exchange rates don't coincide with enjoying international capital


mobility, which is where floating exchange rates come


in.

Fixed foreign-exchange rates

A fixed


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 foreign


exchange rates were used internationally from 1944


to 1973, but now fixed foreign exchange rates


are principally used by small


countries with economies that are essentially


dependent on foreign partners.

 Fixed


exchange rates are


intermittently evaluated for political


and commercial reasons, either being revaluated or


devaluated. A devaluation in a fixed exchange rate lowers


the value of the fixed currency, making exports more


enticing 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 foreign


exchange market , including the currency's


economy, financier sentiment, politics, inflation and rate derivatives.

This is the most


common regime for major economies with two


variants: free floating currencies and managed


floating currencies.

The value of free


floating currencies is solely determined by foreign


exchange market forces and can fluctuate


seriously, providing opportunities for traders to


profit on rising and falling currency values.

Managed floating


currencies are allowed to float to a certain


extent, 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 interest rates or by


purchasing and selling big quantities of currency to bring its currency back to


sufficient levels.

Pegged vs. Floating forex rates

Pegged


foreign exchange rates benefit from reduced risks in


world trade and investment as


world purchasers and sellers can


consent to an amount that won't be vulnerable


to forex rate changes. Pegged


foreign exchange rates can introduce tougher


economic management, keeping inflation under


control, and they can also reduce speculation, which can on


occasion be destabilising to less-established economies.

Nevertheless the


drawbacks of pegged foreign


exchange rates are that there's no automatic


balance of payments between nations without state


interference ; large holdings of forex reserves are


necessary to maintain the pegged rate ; the need to maintain the exchange rate can dominate


monetary policy, which may be better


targeted on other matters ; and


pegged foreign exchange rates can be unstable,


resulting in different rates of inflation causing imbalances between the levels of competition between


different nations.

Countries with


floating foreign exchange rates benefit from


permitting the market to quickly respond to


industrial events, in opposition


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


react very quickly to significant


reports. This also results in automatic


correction in balance of payments adjustments as the exchange rates


adjust to balance supply and demand.

As this


will be taken care of


instantly, governments should have more time to


give policy to other issues.

As floating rates


change mechanically, they don't suffer


from international relations crises that will plague


nations with pegged forex


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

And


nations with floating foreign exchange rates can


have lower forex reserves.

Nonetheless


floating foreign exchange rates result in


unsteadiness and uncertainty when talking about world trade, as fluctuations


may end up in changing prices for imports


and exports. This uncertainty can also lead straight to an absence of foreign investment. Having


said 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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