The forex rate exchange rate regimes that are prominent today didn't exactly start the way it exists now. Initially, before the inception of the foreign exchange markets, the gold standard was the norm where the value of a country's currency was tied to the gold it possessed. The effect of keeping inflation in check was served by the value of money backed by a fixed asset-gold. However, this standard limited the competitive advantage of countries that didn't hold abundant gold reserves and failed to consider businesses and individuals' value resourcefulness to an economy. Thus, the US ended the Gold standard in 1971.
A new global monetary system was established in 1944, enforced by the Bretton Woods agreement wherein a global currency replaced the gold standard. However, the Bretton Woods fixed exchange rate system collapsed after three decades. Since the US had 75% of the world's gold supply at that time, the maintenance of a fixed exchange rate by countries between their currency and the US dollar led to the dollar's increased value and demand.
In a failed attempt to revive the fixed exchange rates, US President Richard Nixon temporarily suspended the dollar's convertibility to gold in 1971. By March 1973, with the inception of major currencies floating against each other, the modern foreign exchange market started its shift from a fixed exchange rate to a floating exchange rate system. Thus, a global decentralized, over the counter (OTC) market for trading currencies evolved, determining the forex rates for each currency.
The evolution of the fixed and floating exchange rate system witnessed new emergences and many downfalls over the years ranging from the International Gold Standard during 1875-1914 to the Bretton Woods System during 1945-1972 to morph into the foreign exchange system prevalent today. The shift has been noticed in not just the evolving systems but also the preferences of countries and its outlook towards the pegged and floating exchange regime with the development of economies and trade. While during the mid-1970s, a massive chunk of countries, amounting to nearly 83%, had some sort of pegged exchange rate, the 1990s observed the gravitation of economies towards the floating exchange rate system.
Depending upon whether the foreign currency exchange rates fluctuate constantly or not, there are two types of exchange rates: fixed and flexible exchange rates. The government of a country can allow the market forces and the economic condition to determine the rate of conversion, or the government can fix a rate by pegging the value of their currency with a stronger and stable currency of another country. No consensus has been reached regarding the perfect foreign exchange rate regime for an economy as the benefits that a country gets would be dependent on characteristics like inflation rate, the magnitude of financial development, size of the economy, capital mobility, etc.
Fixed Exchange Rates
The official rate set and maintained by the government is the fixed or pegged foreign exchange rate. A country holds forex reserves in order to sustain the determined pegged rate agreed between the participating countries and thus witnesses the buying and selling of its own currency by the central bank in the forex market. In a country with fixed exchange rates, the home currency's value is pegged to a major world currency that enables, especially, for the weaker economies to benefit from stimulated trade and greater certainty of navigation against adverse market movements and an upper hand in terms of forex risk management.
Depending on the working mechanism of the fixed exchange rate system, it is classified into the following:
Following are the advantages of a fixed exchange rate:
Following are the disadvantages of Fixed exchange rates:
Floating Exchange Rates
Contrary to the pegged exchange rate, the private market drives and determines the floating exchange rates through supply and demands. It is also referred to as flexible exchange rates. Due to the volatile nature of the forex market and the various factors influencing it, the floating exchange rates fluctuate constantly. The possibility of the central bank's intervention to ensure stability and avoid inflation is not completely absent. Following are the types of floating exchange rates:
Following are the advantages of floating exchange rates:
Following are the disadvantages of floating exchange rates:
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