Exchange Rate Battle: Fixed Rate versus Floating Rate
July 30th, 2010 | 
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The main concept of the currency trading is the exchange rate: exchange rate is the rate at which the currency unit of one country may be exchanged for that of another. To put it differently, exchange rate is the value of a certain currency in comparison to other currencies. Since currencies are traded in pairs, the value of each of them can be defined only through the value of another. The essence of forex trading (and also trading with automated forex systems) is that due to the differences in currency values the profit can be obtained.
In fact, historically there have existed two types of possible exchange rates, namely fixed (which has come into oblivion now) and floating (which is characteristic of the present-day currency market).
Historically the first exchange rate system was that of the fixed exchange rate, according to which the value of one currency was always fixed (pegged) according to the value of another currency. It was the government or the central bank that the determined the exchange rate. Central banks regulated the demand and supply for the currencies within a certain country by means of currency interventions.
Today the fixed exchanged rate system has declined since it turned out to be completely ineffective in terms of the modern market conditions. However, partially fixed exchange rate is maintained effectively in some countries today, for example, in China. Chinese yuan is pegged to the US dollar and the Chinese government is unwilling to float its national currency since the peg is very favorable for the Chinese exports.
The exchange rate system existing today is called floating exchange rate. The value of the currency is defined through the value of another currency – this is the main rule of the floating exchange rate system. Another rule is that exchange rates of certain currencies are determined by the forces of supply and demand for these currencies in the forex market: the higher the demand for a currency in the forex market, the higher its value will be, and vice versa, the higher the supply – the lower the value.
Floating exchange rate is often called self-correcting, because the forex market automatically corrects the differences in supply and demand for the currency: if the demand for a certain currency decreases, it promotes its value falling, thus the local goods and services are becoming more competitive in comparison with the imported ones. The purchasing power of the national currency increases, thus increasing the demand for the national products and facilitating the national economy. This eventually results in the fact that the national economy becomes stronger and accordingly its currency also strengthens, casing the increase of demand for it.
In fact, it must be mentioned that a fusion and interpenetration of exchange rate systems is observed toady – still no pure floating exchange rate system exists worldwide – many countries introduce some elements of the fixed exchange rate either occasionally in order to stabilize their economies in the times of turmoil on a regular basis. It all depends on the country’s economic prerequisites and monetary policies.
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