What are Exchange Rates?
Foreign currency exchange rates measure one currency’s strength relative to another. A strong currency is considered to be one that is valuable, and it manifests itself when comparing its value to another currency. The strength of a currency depends on a number of factors such as its inflation, prevailing interest rates in its home zone, or the stability of the government, to name a few.
What are Fixed Exchange Rates?
A fixed exchange rate (also known as the gold standard) quantifies the values of currencies by using a stable reference point. Historically, gold has been used as the reference point since it is a valuable commodity worldwide and its value is less susceptible to fluctuations in interest rates. The system functioned quite well for the majority of the 1800s but became much less widespread in the 20th century.
The gold standard system pegged the value of gold at US$35 per ounce of gold, which was the reference point that other nations used to fix the value of their currencies. It is important to note that this price was not the commodity price of gold, meaning that private investors could not purchase gold at this price point. Governments had exclusive rights over privateers to buy gold at this below-market price, thus reducing the volatility of currency values.
In 1944, the U.S. pursued an expansionary monetary policy in a bid to financially support the country’s participation in World War II. This policy caused inflation to rise and resulted in the US dollar losing value fairly quickly. Other nations quickly began stockpiling gold to prevent fluctuations in their own currencies.
Eventually, the practice became quite unsustainable due to placing unrealistic demands on the inflation of the US dollar. In 1944, the “Gold Standard” was abolished and was replaced with the Pegged Exchange Rate System.
What are Pegged Exchange Rates?
The pegged exchange rate system incorporates aspects of floating and fixed exchange rate systems. Smaller economies who are particularly susceptible to currency fluctuations will “peg” their currency to a single major currency or a basket of currencies. These currencies are chosen based on which country the smaller economy experiences a lot of trade activity with or based on which currency the nation’s debt is denominated in.
For example, if a small nation that does a lot of trade with the USA decides to peg its currency against the US dollar, its currency will fluctuate in value in roughly the same manner as the USD. The practice eliminates high-magnitude fluctuations and makes the smaller economy’s currency a safer investment. Larger economies would be less hesitant to set up trade deals with such currencies since they will likely not fluctuate beyond reasonable standards.
When pegged exchange rate agreements are set up, an initial target exchange rate is agreed upon by the participating currencies. A fluctuation range is also set in place to outline acceptable deviations from the target exchange rate. Pegged exchange rate agreements usually have to be reviewed several times over their lifetimes in order to adapt the target rate and fluctuations to the current economic climate.
Such systems have proven to reduce the volatility of currencies used in developing economies and have placed pressure on governments to be more disciplined with monetary policy choices. However, this does open up the possibility of investor speculation, which may have an effect on the value of the currency. Pegged rate systems may be abandoned altogether once the weaker currency gains momentum, and sees its pegged value jump ahead of its actual market value.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources: