Countries with flexible currencies have an easier time reacting and adapting to changes in international trade. A flexible currency can balance a country’s imports and exports. If such a country begins to import significantly more than it exports, the supply of its currency on the foreign exchanges will increase. This increase happens because the local currency is exchanged for the foreign currency needed to pay the importers. An increase in supply on the foreign exchanges decreases the value of the currency. This decrease in the currency’s value makes that country’s exports more attractive to foreign buyers. When exports exceed imports the currency supply flows from the foreign exchanges back into the country in the form of payments. This decreases the supply of currency on the exchanges thereby increasing its value. This type of equilibrium coupled with responsible fiscal policies can produce the type of stability that encourages investment. However, in some cases, flexibility can also produce uncertainty which can discourage investment1.
Countries with fixed currencies live with less uncertainty; however, they must maintain large stockpiles of foreign currency to artificially maintain their peg. These stockpiles are used to manipulate the value of their own currency by selling or buying large quantities of it on the foreign exchanges in an effort to devalue or revalue it respectively2.
This strategy has been extremely effective for Saudi Arabia. The value of Saudi Arabian exports (oil) is consistently higher than that of its imports3. If its currency was allowed to float, its supply on the foreign exchanges would be consistently low and therefore its value would be consistently high. This condition would lead to high levels of inflation for Saudi Arabia4.