The currency exchange rate as a phenomenon emerged due to a necessity to develop and maintain trade and financial transactions among distinct states. From the very beginning, it was meant to establish a particular correlation between national currencies. Usually, the fixed and the floating rate of exchange are distinguished. The differences between them will be discussed in greater detail in the given paper.
Fixed and Floating Exchange Rates: Explanation
Overall, the primary feature of the fixed exchange rate is that its fluctuations occur within a small range. It implies a rigid binding of the national currency to another currency or a certain set of foreign currencies: US dollars, Euros, GBP, et cetera. Such a rate remains unchanged for a long time, regardless of fluctuations in the demand and supply of a given currency. As stated by Frieden (2014), this regimen is used as “an anti-inflationary commitment device” (p. 11). The set rate is maintained through the central bank’s interventions, namely, the purchase and sale of foreign currency in exchange for the national one. For instance, if the demand for the national currency grows, its rate slightly rises. However, the central bank should maintain the fixed exchange rate at the initial level. Thus, to return it there, the central bank intervenes and increases the supply of the national currency by buying (demanding) the foreign one.
Compared to the fixed rate of exchange, the floating exchange rate system suggests that exchange rates are regulated by the market mechanisms and may be associated with a significant fluctuation. In other words, they are formed by the demand-supply ratio in the foreign exchange market (Saidi, 2017). Therefore, there is no need for the central bank to intervene and maintain the balance of payments as it is carried out through the inflow and outflow of capital.
An example of a fixed currency is the Bahraini Dinar (DHD). The government fixed it at the peg rate of 0,376 per 1 US dollar, and it slightly fluctuates between 0,374 and 0,380 since 2001. As per 2018 July 25, the BHD rate was 0,3756 and 0,3754 on July 26 (OANDA, 2018). At the same time, the US dollar, as well as many other main currencies, is a floating currency, and its rate depends on how it is traded in the foreign market. For instance, the exchange rate between the USD and Euro was 1 to 1,06 in January 2001, while the current exchange rate is 1 per 0,8242 (OANDA, 2018). Compared to the fixed DHD, it shows more fluctuation.
As the analysis reveals, in general, the currency exchange rate is set depending on the ratio of demand for the national currency and supply of the national currency in the foreign exchange market. At the same time, the exchange rate grows in case the demand for goods of a particular country rises. In other words, it grows when the volumes of exports increase, which causes the inflow of foreign currency into the country. Overall, Isaac (2015) notes that when the demand for financial assets of the country increases, it results in a positive balance of the capital account. It means that the depreciation of the national currency occurs when the country expands the demand for imported goods and foreign financial assets. As a result of the growth in the volumes of imports, the current account deficit appears. Due to the growing demand for foreign financial assets, capital outflows take place, and the balance of the capital account becomes negative (Kandil, 2009). In this case, there is a deficit in the balance of payments.
It is observed that the performance and the output of most enterprises can largely depend on the exchange rate. As stated by Musa (2014), exchange rate movements that arise from currency fluctuations in the foreign exchange markets affect “both the cash flow of a firm’s operations and the value of a firm” (p. 2). It means that volatility is associated with some serious risks, including uncertainty in the investment market (Musa, 2014). For this reason, it is possible to say that smaller, established businesses that operate in the international markets can be more sensitive to exchange rate movements, while the larger and emerging companies, focusing on domestic operations mainly, can be influenced by them to a lesser extent.
Overall, it seems that the fixed exchange rate helps reduce businesses’ exposure to foreign currency risks better as it implies the equilibration of the balance of payments through the central bank’s interventions. These interventions help avoid a chronic surplus of the balance of payments and over-accumulation of official reserves, which may lead to inflation. With the chronic surplus of the balance of payments, there is a threat of complete depletion of official reserves since, in the conditions of their reduction, the central bank will have to increase the supply of foreign currency continually to maintain the fixed exchange rate. As a consequence, the central bank may be forced to officially change the exchange rate of the national monetary unit or, in other words, reevaluate its price relative to other currencies. In some cases, the devaluation of national currency may occur. Nevertheless, the effectiveness of the given practice largely depends on the import and export demand elasticity. At the same time, it is worth noting that a controlled floating exchange rate is associated with a more open flow of capital and an increased level of international trade. Overall, the choice of the regimen must be defined by particular country characteristics and contexts.
Frieden, J. A. (2014). Currency politics: The political economy of exchange rate policy. Princeton, NJ: Princeton University Press.
Isaac, L. (2015). Assessing the impact of exchange rate risk on banks performance in Nigeria. Journal of Economics and Sustainable Development, 6(6), 1-13.
Kandil, M. (2009). Exchange rate fluctuations and the balance of payments: Channels of interaction in developing and developed countries. Journal of Economic Integration 24(1), 151-174.
OANDA. (2018). Web.
Saidi, N. A. H. (2017). Essays on rational expectations and flexible exchange rates. New York, NY: Routledge.