Bilateral Nature of Exchange Rates

bilateral-nature-of-exchange-ratesThe rate at which one currency is exchanged for another is called an exchange rate. To put it otherwise it represents the value of one country’s currency as compared to that of another. Currency exchange rates are grouped into two main sub domains: Fixed Exchange Rates and Floating Exchange Rates.

Fixed Exchange Rates
A fixed exchange rate which is also known as a pegged exchange rate signifies the fixed nature of a currency against the value of another currency. It is set by the government (central bank) which in order to maintain its currency buys and sells it on the Forex market in return for the currency to which it is fixed.

In case of fixed rates there is less speculative activity which mainly depends on whether Forex market dealers consider a given fixed exchange rate appropriate and credible or not.

Fixed exchange rates put a discipline on employees and domestic firms to keep their costs under control as to remain competitive in international markets. This is of great help for the government to maintain low inflation by bringing interest rates down and stimulating increased trade and investment.

Floating Exchange Rates
A floating exchange rate is not determined by the government. It is determined by a private market based on supply and demand. This type of exchange rate undergoes certain fluctuations depending on the foreign exchange market.

Therefore any difference in supply and demand will automatically affect the market. This can be explained in the following way: the low demand for a currency causes the decrease of a currency value. This makes the imported goods more expensive and enlarges the demand for local goods and services. As a result more jobs will be generated, causing “self- correction” in the market.

Such currencies convey most heavily traded currencies like the United States dollar, the Euro, the Australian dollar, the British pound,the Norwegian crone, the Japanese yen, and the Swiss franc. A model of an ideal floating currency is the Canadian dollar as the Canadian central bank since 1998 has not interfered with its price. Conversely, Japan and the United Kingdom intervene to a greater extent.

No currency is absolutely fixed or floating.However the major part of currencies is floating. Sometimes when the true value of a local currency against its fixed currency becomes evident central bank becomes compelled to revalue or devalue the official rate in order to prevent the development of “black market”. Central bank may also interfere in such cases as to prevent inflation and ensure stability.

While comparing these two currency rates it becomes obvious that a fixed exchange rate represents a nominal exchange rate which is set and maintained by the monetary authority. On the other hand a floating exchange rate, as determined by Forex markets, fluctuates constantly depending on supply and demand. Moreover, it also turned out that monetary authorities have all the possibilities and the right to freely and flexibly determine, as well as maintain floating exchange rates.

1.    Peter B. Kenen, Fixed versus floating exchange rates; Cato Journal, Vol. 20, No. 1 (Spring/Summer 2000)