An exchange rate is a rate at which one currency trades for another on the foreign exchange market. Rates of exchange are determined by demand and supply in the foreign exchange market. There are two extreme possibilities in exchange rate Fixed exchange rate. Floating exchange rate.
2.1 Fixed Exchange Rate Fixed Exchange Rate is a rate of exchange between currencies which is set by the governments rather than allowed to change freely with market forces. In order to keep currencies trading at the fixed levels, government economy authorities actively enter the currency market to buy and sell according to variations in supply and demand.
2.2 Floating Exchange Rate The rate between two currencies that is allowed to fluctuate with the market forces of supply and demand. Floating exchange rates is uncertain as to the future rate at which currencies will exchange, because no one can predict rate in floating exchange rate. The uncertainty is due to increased popularity of forward, futures, and option contracts on foreign currencies. Floating exchange rate is also known as flexible exchange rate.
3. Example of Fixed Exchange Rate Let's have some clear idea of Fixed Exchange Rate by studying following example From the above figure we can say that initially the market of Australian dollar is stable, at 0.96 the supply of dollar is exactly equal to the demand of dollars. There is not need of government intervention to maintain the exchange rate. Assuming the demand of Australian beef is decreasing due to some reason and U.S citizen switch to other country for beef. In this situation Australian product shifts the U.S demand curve for the Australian dollar to the left. U.S demand fewer Australian dollars at ever exchange cost (Cost of an Australian dollar) as it is purchasing less from Australia than it did before. If there were no restriction on trade and assuming the price of Australian dollar were set in such a free market, the shift in the demand curve would lead to a fall in the price of Australian dollar, just the way the price of wheat would fall if there was an excess supply of wheat. U.S and Australian government have committed themselves to maintain the rate at 0.96. To do so either U.S government or Australian government or both must buy up the excess supply of Australian dollars to keep its price from falling. In short, this works when government promises to act as the supplier or demander of last resort. It will ensure that the amount of foreign exchange demanded by the private sector will equal the supply at the fixed price.
4. Fixing the Exchange Rate
Considering an example of an organization i.e. The Bank of Latvia The Bank of Latvia has chosen the fixed exchange rate policy for the implementation of monetary policy. Under this strategy, the Bank of Latvia's intermediate target is the external stability of the national currency, i.e. the peg of the lats to the euro (at the rate 1EUR = 0.702804 LVL). The normal fluctuation margin around the fixed peg rate is +/- 1%. The Bank of Latvia performs interventions when the exchange rate of the lats exceeds the normal fluctuation margin of +/- 1%. Lats has been pegged to the euro from January 1, 2005. The Bank of Latvia ensures the external stability of the lats under free capital movement and unlimited convertibility of the national currency. Latvia has also established one of the most liberal foreign exchange and capital movement regimes in the world. Both foreign currency and lats can freely enter and leave the country, accounts can be opened in lats and foreign currency without any restriction and lets can be easily purchased and sold freely in exchange for the foreign currency. By this policy foreign investors can earn their profit in any currency without any restriction.
5. Why was the fixed exchange rate strategy chosen? A fixed exchange rate strategy is appropriate for the Latvian economy for other reason as well which are not related to the prospective participation in the EMU, therefore Latvia has maintained the above strategy. Firstly, a fixed exchange rate policy is appropriate for the small countries with an open economy, where foreign trade plays a very important role. In such countries , single major transaction may cause considerable short term exchange rate fluctuation, increasing foreign expenditure and risk. Secondly, in Latvia's monetary transmission mechanism, the exchange rate channel affects consumer price dynamic considerably. That can be largely attributed to quite a high imports component both in Latvia's consumption, as well as manufacturing. Having implemented the fixed exchange rate policy for the several years, it is evident that it was the right choice and this policy is still appropriate for the Latvian economy.
6. Advantages & Disadvantages of Fixed Exchange Rate
6.1 Advantages of Fixed Exchange Rate. Any changes in the exchange rate can affect the market values of assets that are denominated in foreign currencies. This can increase the financial risks that a nations residents face, thereby forcing them to incur costs to avoid these risks. The possibility that variations in the market value of assets can take place due to changes in the value of a nation's currency is the foreign exchange risk that residents of a country face because their nation's currency value can vary. In above case if any company in Latvia had many loans denominated in Euro but earned nearly all their in Lats from sales within Latvia, a decline in the Euro value of the Lats would mean that Latvian companies would have to allocate a larger portion of their earning to make same Euro loan payments as before. Thus a fall in the Lats value would increase the operation costs of these companies, thereby reducing their profitability and +raising the likelihood of eventual bankruptcy. Therefore limiting foreign exchange risk is a classic decision for adopting a fixed exchange rate. For example a company in Latvia that has significant U.S dollar earnings from sales in any of the US city but quite large loans from UK investors could arrange to converts its dollars earnings into pound through special types of foreign exchange contracts. The Latvian companies could likewise avoid holding of Lats and thus protect itself against variation in the Lats Value. Reduce risk in International Trade: - As the rate of the exchange will be fixed so there won't be any risk in International trade, companies don't have to face high fluctuation of exchange rate. Government:-Fixed Exchange helps governments to keep the rate of inflation approximately to world levels provided there are not trade restrictions. Thus a fixed exchange rate prevents governments pursuing irresponsible macroeconomic policies.
6.2 Disadvantages of Fixed Exchange Rate. Large holdings of foreign exchange reserves required: - Just to keep exchange rate stable countries require lots of cash or gold in their hand so that at the time of fluctuation in rate they can stable their rate. In this case government of that country have to hold different currencies in large proportion. Loss of freedom in your internal policy: - The needs of the exchange rate can dominate policy and this may not be best for the economy at that point. Interest rates and other policies may be set for the value of the exchange rate rather than the more important macro objectives of inflation and unemployment. Huge pressure on under developed countries: - There will be huge pressure to under developed countries by developed and developing countries to devaluate their rate at the time of inflation. Like wise unemployment problem rises in underdeveloped countries. Over Valuing: - With fix exchange rates and an overvalued currency, the monetary authorities will be suffering a loss of reserves. It is this that causes balance of payments crises for governments operation under fixed exchange rate regimes.
7. Conclusion Under different circumstances, one can conclude that some nation's like Latvia adopt fixed exchange rate regime for business in international trading while some nation's allow the exchange rates to float. By adopting fix exchange rate the bank of Latvia is capable to maintain a stable lats exchange rate even in case of any external disorders.