Why Governments Use Fixed Currency Rates in Foreign Exchange Market

The rate of exchange of foreign currencies in Nigeria today fluctuates rapidly every day.

Most major world currencies fluctuate freely around the currency exchange market, when compared to the so-called “pegged currencies”, which can be linked with other major currency.

The two common types of fixed rate foreign currency system consist of a fixed and unconvertible exchange rate, and a fixed and convertible exchange rate. The initial approach to fixing the exchange rate involves a ban on the free conversion with the local currency in a foreign currency while the second one features free industry for foreign exchange, but fixes the Forex rates in the local currency.

The pegged currencies cannot float freely in the foreign exchange market with their currency rates fluctuate in conjunction with the fluctuations of the base currency. Thus, a currency pegged towards the euro follows all moves with the single European currency in the Forex markets.

This kind of system offers basic protection against collapses with the rate of exchange of the local currency, but makes it dependent on a foreign currency with the risks related to sudden weakening from the base currency.

However, rivals with the fixed rate exchange regimes argue that they are in contradiction on the basics of the free market system; hence, they’re inefficient and dangerous in times of financial crisis because this type of Forex regime does not provide shelter for that local currency.

The free-floating currencies are more able to adjust to financial market shocks, critics claim. Another disadvantageous feature of the fixed exchange rate could be that the government is forced to maintain large foreign exchange reserves to maintain the fixed currency rate levels.

Among some great benefits of the fixed Forex trading regime is the increased confidence from the investors in a particular currency and also the decreased trade and investment risks due to the not enough fluctuations surrounded by the rate of exchange.

In addition, theorists claim that a fixed exchange rate also suppresses inflation, the curse for conducting business and prevents entrepreneurs from long-term planning.

Normally, the fixed exchange rate is considered a short-term measure for stabilization of the local economy or like a tool employed in preparation for major economic reforms. However, there are countries in Europe, whose currencies are already pegged for years without causing any difficulty to the local economies.

Alternatively, one of the most restrictive set rate foreign currency regimes could be observed among the less economically developed nations and there is no evidence that the introduction of such regulations boosted the area economies, analysts reported.

The advantages and disadvantages with the free floating and fixed currency rates have been subject of debate for many years; nevertheless, the widespread opinion is the floating exchange rate is more advantageous for the majority of the developed market economies.

Some experts believe the fixed currency rates are old-fashioned concept, but whether it’s a great tool, the government doesn’t have other choice but to peg its currency into a major world currency to protect their economies.

So, in your opinion, why do you think the governments use fixed currency rates on foreign exchange market? You can leave your comment below.

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