EXCHANGE RATES EXPLAINED - FOUR

The Pegged Exchange Rate

There are two systems for exchange rates and determining the value. The pegged curency and the floating currency.

An exchange rate can be set in stone by a government. This is called the pegged or fixed system. The rate is pegged, or attached to some other currency, usually the U.S. dollar. This rate is maintained by the governement as needed.

A government tries to keep its currency stable, for both good and bad economic times in their country. They need to hold reserves to deal with sudden demands as well as buying up currency to keep the price stable.

A pegged system can be found in more unstable countries or developing nations. This is where black markets can also grow and thrive if the currency is not at a valid level. In other words, people disagree with the government and trade at their own levels.

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Floating Exchange Rates

There are two main systems used to determine a currencys exchange rate: floating currency and pegged currency .

The market determines a floating exchange rate. In other words, a currency is worth whatever buyers are willing to pay for it. This is determined by supply and demand , which is in turn driven by foreign investment, import/export ratios, inflation, and a host of other economic factors.

--------------Find a Floating System You can see a floating system at work. In recent months, changes in the U.S. and Canadian economies have led to the Canadian dollar becoming worth more. For years, a Canadian dollar was worth about 65 cents. Since the beginning of 2003, it has risen to 75 cents. Look in the business section of your newspaper, or check an exchange rate calculator on the Internet , and track the Canadian dollars rise in value yourself. Right now, economists aren't sure how high it will go. ----------------

Generally, countries with mature, stable economic markets will use a floating system. Virtually every major nation uses this system, including the U.S., Canada and Great Britain. Floating exchange rates are considered more efficient, because the market will automatically correct the rate to reflect inflation and other economic forces.

The floating system isn't perfect, though. If a countrys economy suffers from instability, a floating system will discourage investment. Investors could fall victim to wild swings in the exchange rates, as well as disastrous inflation .

Pegged Exchange Rate

A government has to work to keep their pegged rate stable. Their national bank must hold large reserves of foreign currency to mitigate changes in supply and demand. If a sudden demand for a currency were to drive up the exchange rate, the national bank would have to release enough of that currency into the market to meet the demand. They can also buy up currency if low demand is lowering exchange rates.

Countries that have immature, potentially unstable economies usually use a pegged system. Developing nations can use this system to prevent out-of control-inflation. The system can backfire, however, if the real world market value of the currency is not reflected by the pegged rate. In that case, a black market may spring up, where the currency will be traded at its market value, disregarding the governments peg.

When people realize that their currency isn't worth as much as the pegged rate indicates, they may rush to exchange their money for other, more stable currencies. This can lead to economic disaster, since the sudden flood of currency in world markets drives the exchange rate very low. So if a country doesn't take good care of their pegged rate, they may find themselves with worthless currency.

Hybrid Exchange Rates

Floating systems aren't really left to the mercy of market forces, either. Governments using floating exchange rates make changes to their national economic policy that can affect exchange rates, directly or indirectly. Tax cuts, changes to the national interest rate, and import tariffs can all change the value of a nations currency, even though the value technically floats.

The next time you cross a border, and trade your money for that of another country, remember that economic forces across the world helped determine that exchange rate. In fact, when you exchange currencies, you're one of those economic forces -- you're helping to set the exchange rate, too.

Although this system works pretty well most of the time, its not always the best solution.

Euro

The original seed for a common currency was planted in 1946 when Winston Churchill suggested the creation of the "United States of Europe." His goals were primarily political, in that he hoped a unified government would bring about peace for a continent that had been torn apart by two world wars.

Although the euro is fundamentally a tool to enhance political solidarity, it also has the economic effect of unifying the economies of participating countries. Some of the euros advantages, in regard to economics, include:

• Elimination of exchange-rate fluctuations - The euro eliminates the fluctuations of currency values across certain borders.
• Transaction costs - Tourists and others who cross several borders during the course of a trip had to exchange their money as they entered each new country. The costs of all of these exchanges added up significantly. With the euro, no exchanges are necessary within the Euroland countries.
• Increased trade across borders - The price transparency, elimination of exchange-rate fluctuations, and the elimination of exchange-transaction costs all contribute to an increase in trade across borders of all the Euroland countries.
• Increased cross-border employment - With a single currency, it is less cumbersome for people to cross into the next country to work, because their salary is paid in the same currency they use in their own country.

For more information on exchange rates and related topics, check out the links on the next page.

Defining Exchange Rates

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