Do you plan to send money across borders to family or friends? Have a big international trip soon? Do you ever buy products from other countries?
If you answered yes to any of these questions, a crash course in the different types of exchange rates might do you some good. Understanding —and the different types—makes navigating the foreign exchange (forex) markets a little easier.
This article digs into the three main types of currency exchange rates: fixed, floating, and managed systems.
3 types of exchange rates
The three main types of exchange rates differ in how currency values are determined. These differences emerged from the evolving global monetary system over centuries:
- In the gold standard era, currency values were “fixed” as weights of gold. This system established fixed exchange rates and acceptance of government intervention in currency markets.
- By the 1970s, a global dominated, with supply and demand setting currency values on foreign exchange markets.
- A managed floating exchange rate system is a hybrid of both systems. Here, market forces determine currency values, with occasional government intervention.
Knowing the different types of exchange rates and how they work makes converting currencies to send money internationally or travel overseas a little less intimidating. Let’s explore floating, fixed, and managed floating rates more in depth.
Fixed exchange rate
Fixed exchange rate systems, sometimes called currency pegs, determine a currency’s value by linking it to another currency, a basket of currencies, or a precious metal. The goal is to maintain exchange rates within a narrow range.
- How it works: Governments and central banks actively manage currency values using various monetary policy tools. These tools include buying or selling domestic currency, currency reserve management, interest rate adjustments, and quantitative easing (injecting new money into the economy).
- Benefits: Fixed exchange rate systems can offer stability and predictability. Developing economies may use them to curb inflation and attract foreign investment.
- Who fixes their exchange rates: The Hong Kong dollar and Saudi Arabian riyal are both pegged to the US dollar (USD).
Floating exchange rate
Floating exchange rates, also known as flexible exchange rates, determine currency values by supply and demand in foreign exchange markets.
- How it works:Currency values fluctuate freely without direct intervention from the government or central bank. Beyond supply and demand for the currency, other key factors can influence exchange rates. These include economic conditions, trade balances, investor sentiment, interest rates, inflation, and economic performance.
- Benefits:Floating exchange rate systems have become the dominant model, as they provide flexibility and promote international trade and investment.
- Who floats their exchange rates: Major economies that float their currencies include the United States, the European Union, and the United Kingdom.
Managed floating exchange rate
Managed exchange rate systems, also known as “dirty floats,” determine a currency’s value primarily through market forces and some intervention from governments and central banks. This system combines elements of both floating and fixed exchange rates.
- How it works: Supply and demand are the main influences on currency values. However, governments may occasionally intervene to manage exchange rates. Interventions may include interest rate adjustments, capital controls, and buying or selling foreign currencies.
- Benefits: Managed exchange rates offer stability while enabling adjustment to changing economic conditions.
- Who manages their exchange rates: China, Vietnam, and Singapore use managed systems to keep their exchange rates in check.
Floating vs. fixed vs. managed floating exchange rates
| Exchange Rate Type |
Exchange Rate Determination |
Government Intervention |
Example |
Pros |
Cons |
|
Floating |
Currency value determined by supply and demand in the foreign exchange market |
Limited |
|
|
|
|
Fixed |
Currency value pegged to another currency, a basket of currencies, or another asset Pegged at set rate by government |
Ongoing |
|
|
Can cause trade imbalances and loss of monetary policy independence |
|
Managed Float |
Hybrid of floating and fixed exchange rate systems |
Occasional |
|
Can balance flexibility and stability |
Requires active management |
FAQs
What are the different types of exchange rates?
The three primary types of exchange rates are fixed, floating, and managed systems. They differ in how currency values are determined:
- In floating exchange rate systems, foreign exchange markets determine currency values.
- In fixed exchange rate systems, governments and central banks determine currency values.
- Managed exchange rates are a hybrid of the two. Foreign exchange markets determine exchange rates, with occasional intervention by monetary authorities.
What is the most commonly used exchange rate type?
Floating exchange rates are the most common exchange rate regime type today. Under this system, market forces of supply and demand determine currency values without direct intervention from governments or central banks.
Major economies like the US, European Union (EU), UK, Australia, and others employ floating exchange rates.
However, it’s worth noting that the global economy has elements of both free-floating and managed systems, as central banks occasionally intervene to stabilize currency valuations.
What are the differences between the types of exchange rates?
The three main types of exchange rates primarily differ in how currency values are determined.
- Floating exchange rates fluctuate freely, and currency values are determined purely by the foreign exchange markets.
- Fixed exchange rates are set by governments or central banks and require ongoing management to uphold pegged values.
- Managed floating exchange rates blend elements of both systems. Under this system, market forces mainly determine currency values, with occasional intervention from governments and central banks.
