Being the main force driving the global economic market, currency is no doubt an essential element for a country. However, in order for all the countries with different currencies to trade with one another, a system of exchange rate between their currencies is needed; this system, is formally known as foreign exchange or currency exchange.
In the early days, the system of currency exchange is supported solely by the gold amount held in the vault of a country. However, this system is no longer appropriate now due to inflation and hence, the value of one’s currency nowadays is determined through the market forces alone. In order to determine the value of a currency’s exchange rate, two main types of system is used which is floating currency and pegged currency.
For floating exchange rate, its value is determined by the supply and demand of the global market where the supply and demand is bound by all these factors such as foreign investment, inflation and ratios of import and export. Normally, this system is adopted by most of the advance countries like for example UK, US and Canada. All of these countries have a similarity where their market is well developed and stable in economic terms. These countries choose to practice this system due to the reason where floating exchange rate is proven to be much more efficient compared to the pegged exchange rate. The reason behind this is because for floating exchange rate, the market itself will re-adjust the exchange rate real-time in order to portray the actual inflation and other economic forces. However, every system has its own flaw and so does the floating exchange rate system. For instance, if a country suffers from economic instability due to various reasons such as political issues, a floating exchange rate system will certainly discourage investment due to the high risk of suffering from inflationary disaster or sudden slump in exchange rate.
Another form of exchange rate is known as pegged exchange rate. This is a system where the value of the exchange rate is fixed by the government of a country and not the supply and demand of the market. This system is called pegged exchange rate because the value of a country’s currency is fixed to another country’s currency. As a result, the value of the pegged currency will not fluctuate unlike the floating currency. The working principle behind this system is slightly complicated where the government of a country will fixed the exchange rate of their currency and when there is a demand for a certain currency resulting a rise in the exchange rate, the government will have to release enough of that currency into the market in order to meet that demand. However, there is a fatal flaw in this system where if the pegged exchange rate is not controlled properly, panics may arise within the country and as a result of that, people will be rushing to exchange their money into a more stable currency. When that happens, the sudden overflow of that country’s currency into the market will decrease the value of their exchange rate and in the end, their currency will be worthless. Due to this reason, only those under-developed or developing countries will practice this method as a form to control the inflation rate.
However, the truth is, most of the countries do not fully practice the floating exchange rate or the pegged exchange rate method in reality. Instead, they use a hybrid system known as floating peg. Floating peg is the combination of the two main systems where one country will normally fixed their exchange rate to the US Dollars and after that, they will constantly review their peg rate in order to stay in line with the actual market value.
The Foreign exchange market, or commonly known as FOREX, is the largest and most prolific financial market because each day, more than 1 trillion worth of currency exchange takes place between investors, speculators and countries. From this, we can deduce that the actual mechanism behind the world of foreign exchange is far more complicated than what we may already know, and that, the information mentioned earlier is just the tip of an iceberg. SOURCE
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