Posts Tagged ‘currencies’

Pegged or Free Floating Exchange Rates

What is the difference between a pegged exchange rate and a free floating exchange rate ?

A free floating currency exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world.

A pegged currency maintains a fixed currency exchange rate against other currencies. This rate is often determined by the government or central bank of that currency.

Countries that have immature, potentially unstable economies usually use the pegged system. Developing nations can use this system to prevent out-of control-inflation. The disadvantage of the system is that it can backfire if the value of the currency does not really show the true value of the currecny. A black market may spring up, where the currency will be traded at its market value, disregarding the government’s peg.

Exchange Rates Fluctuations

A market based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply like in normal markets. It will become less valuable whenever demand is less than available supply.

Growing demand for a currency is due to either an increased  demand for money, or an increased speculative demand for money.

The transaction demand for money is highly correlated to the country’s level of business activity, gross domestic product (GDP), and employment levels. The more people there are unemployed, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions.

The speculative demand for money is much harder for a central bank to accommodate but they try to do this by adjusting interest rates. An investor may choose to buy a currency if the return (that is the interest rate) is high enough. The higher a country’s interest rates, the greater the demand for that currency. It has been argued that currency speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency in order to force that central bank to sell their currency to keep it stable (once this happens, the speculator can buy the currency back from the bank at a lower price, close out their position, and thereby take a profit). Speculative demand is the main reason for some currencies fluctuating exchange rates.

Exchange Rates Market

In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specifies how much one currency is worth in terms of the other. It is the value of a foreign nation’s currency in terms of the home nation’s currency. For example an exchange rate of 7  South African Rand (ZAR, R) to the United States dollar (USD, $) means that ZAR 7 is worth the same as one USD . The foreign exchange market is one of the largest markets in the world. By some estimates, about 3.2 trillion USD worth of currency changes hands every day.