The difference between fixed & floating exchange rates

Written by robert alley
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The difference between fixed & floating exchange rates
Exchange rates allow trade between currencies. (money money money image by Tribalstar from Fotolia.com)

Exchange rates determine the value of money when exchanged. A fixed exchange rate means the amount of currency received is set in advance. A floating exchange rate means that the rate is moving and the currency received depends on the time of the exchange.

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History

Unitl 1971, governments with the major currencies in the world maintained fixed exchange rates. The rates were originally based upon the price of gold, and then the value of the US dollar. Fixed exchange rates allowed for stability. Everyone knew the cost of money. There was no uncertainty in the foreign trade of goods. After 1971, governments with major currencies, such as the United States and European countries, could no longer control the exchange rate and the rate was allowed to float. In many developing countries governments continued to use a fixed exchange rate for their currency.

The difference between fixed & floating exchange rates
At one time, the value of gold kept exchange rates fixed. (gold image by Witold Krasowski from Fotolia.com)

Fixed exchange rate

A fixed exchange rate is based upon the government's view of the value of its currency as well as the monetary policy. It has advantages. Stability is one. Another is predictability. Businesses and individuals can plan their activities with the certainty of the value of money. A businessman shipping goods overseas knows the value in advance. A tourist travelling in other countries can budget knowing what his money will buy.

The difference between fixed & floating exchange rates
Fixed exchange rates are set by governments. (good exchange rate image by Christopher Nolan from Fotolia.com)

Floating exchange rate

The floating exchange rate, in its true form, allows the marketplace to set the rate. The forces of supply and demand determine the value of a currency. For example, when the US dollar is considered strong it will take more euros, the currency of most European countries, to buy. When the US dollar is considered weak or in decline the amount of euros needed to buy it will fall.

Controlled floating rates

In reality, floating rates do not solely change with the forces of the marketplace. Governments are constantly trying to fix the floating rate by taking action in the marketplace. Government action cannot fix the rate, but it can effect the rate through intervention. Such intervention involves either the buying or selling of currency, depending on which way the government wants the rate to go.

The difference between fixed & floating exchange rates
(Dollars and euros image by TekinT from Fotolia.com)

Modified fixed rate

Some governments, like China, have a modified fixed rate. They set a rate and then allow the rate to float within certain defined limits. Such limits are usually very small. These small allowed changes mean that the rate will always come back to the set figure after going up or down. For China, it is a way to put a small amount of free market in the currency while maintaining government control.

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