The forces of supply and demand determine the value of a currency. Other factors, including economic health, affect the value as well. When demand is higher than supply, the currency’s value will decline. In an economy with sound fiscal policy, using a floating currency can be advantageous. In a down economy, devaluation may occur due to market sentiment. If the currency is unstable, a government can intervene to control it.
Reduce transaction costs
Fixed exchange rates have several advantages over floating exchange rates. First of all, these rates are more stable. Therefore, they can help reduce transaction costs for foreign investors. Second, fixed exchange rates can promote international trade and investment, which are important sources of growth in the long run, especially for developing countries. However, the merits of fixed exchange rates are debatable, and a nation’s economic interdependence with its neighbors will determine which type of exchange rate is more suitable for it.
Fixed exchange rates allow the government of a country to control the value of its currency. However, these fixed exchange rates may contribute to currency crises, which may result in a wider economic crisis. Floating exchange rates, on the other hand, allow economies to stabilize, as the central bank can reduce interest rates and export prices to promote economic growth.
Fixed exchange rates were first introduced when global trade was less liquid, and the risk of foreign exchange fluctuation was virtually eliminated. However, the Bretton Woods agreement broke down when the United States began printing more money to fund the Vietnam War. Other countries were no longer willing to inflate their own money supply in order to maintain a peg with the United States dollar. The resulting devaluation would not only hamper global trade but would also hinder central banks from managing their own economies.
Promote international trade
Fixed and floating exchange rates are two different ways to trade in the forex market. The former is based on the current value of a currency, and the latter is based on the country’s economic situation. The former is characterized by greater market efficiency. Floating exchange rates do not require central banks to keep large amounts of foreign currency reserves, which they can use for other purposes, like promoting economic growth.
With a floating rate, the value of a currency is determined by the private market through supply and demand. It is often referred to as “self-correcting,” as the price of a currency may drop if there is not enough demand. This situation helps generate more demand for local goods and services and creates more jobs.
While it is true that central banks can affect the value of a currency, they are not as influential as a government’s policy decisions. For example, Turkey’s central bank reduced interest rates after the currency plunged in value. In addition, the record level of foreign debt in India will soon challenge the forex reserves of the country. These factors have far-reaching effects on the value of a currency.
Promote stability
In forex trading, it is important to understand the difference between fixed and floating exchange rates. Fixed exchange rates are determined by the government while floating exchange rates are determined by the private market. Floating exchange rates are more volatile and may be erratic in nature. In addition, they can be dangerous for a country’s economy if they cause the value of the currency to decrease.
In general, fixed rates are preferred by traders and investors alike. Fixed exchange rates are also a good choice for novices who are just beginning their forex journey. Fixed rates are easier to manage as they have fewer restrictions and are easier to predict. Floating exchange rates are more volatile, though they are not as volatile as fixed rates.
Fixed rates are generally more stable and are more flexible, but some observers have expressed concern. Many emerging market economies have experienced large-scale financial crises, and these crises are likely to have negative consequences on their currency. This is especially true if a country doesn’t have adequate foreign exchange reserves.
Promote economic growth
Floating and fixed exchange rates are important in forex trading as they help promote economic growth and improve efficiency in the market. Floating rates increase trade efficiency by allowing central banks to spend their foreign currency reserves on other purposes. Fixed rates can make it difficult for a country to increase its economic growth while floating exchange rates can help it grow without importing inflation.
While floating exchange rates are often the most popular currency pair, there are some drawbacks. They are more volatile than fixed ones and can result in high volatility for traders and investors. Fixed exchange rates are generally preferred by central banks, as they help develop economies by encouraging regular international trade relations. Floating exchange rates are typically found in established economies. Although some countries have used fixed exchange rates during times of severe economic instability, most countries adopted floating rates after the Bretton Woods system and the gold standard ended.
Fixed exchange rates are more efficient in promoting economic growth because they can help maintain the inherent value of a currency relative to another. However, they can also hinder economic growth because they cause more volatility and lower productivity growth. However, this is outweighed by the positive effect of lower volatility and higher GDP growth that come from the move to floating exchange rates.