Determination Of The Exchange Rate

What is Exchange Rate?

The exchange rate is the price of a currency in comparison to another currency. It is either fixed by the central bank or determined by the market demand of demand and supply. When the central bank fixes the exchange rate, it is known as the fixed exchange rate. On the other hand, when the rate is fixed by demand and supply, it is known as a floating exchange rate.

Characteristics of Exchange Rate

An exchange rate is an indispensable tool in facilitating international trade.

• It also shows the comparative value of the currency. By making it easier to make transactions with international partners, exchange rates help countries to trade without any barriers. Therefore, in terms of functions, exchange rates are invaluable.

• By checking the exchange rates, economists also determine the economic well-being of a country. If too much of fluctuations in the currency exchange rate occurs, the authorities must intervene to make the rates fixed. This helps the economy stay stable and any chance of an economic downturn could be thwarted.

• When a country imports goods in bulk, the demand usually pushes up the exchange rate for that country. This makes the imported goods more expensive to consumers in that country. When the goods become increasingly expensive, demand drops, and the country’s money becomes cheaper in comparison to other countries’ money. Therefore, the country’s commodities become cheaper to buyers abroad, demand goes up, and export from the country increases.

• World trade now depends on a hybrid system of the exchange rate which can be called managed floating exchange system. In such as system, governments intervene to stabilize their countries’ exchange rates by stimulating exports, limiting imports, or devaluing the currencies.

Although a very important concept for international trade, the establishment of exchange rates is not a very old phenomenon. It was established after the second world war in the 20th century.

Exchange Rate Determination

There are numerous methods of calculating the exchange rate of currencies. Some popular methods are -

• Floating Exchange Rate
• Fixed Exchange Rate
• Flexible Exchange Rate.

Floating Exchange Rate

An exchange rate that is not fixed is called a flexible exchange rate. The flexible exchange rate fluctuates from one value to another. The market determines whether the exchange rate moves or not. The term "floating currency" is used to indicate any currency subject to a floating regime.

For example, the US dollar is an example of a floating exchange currency.

Floating rates are notable and are very popular among economists. The believers in a free market are of the mindset that markets should determine the currency value. The USD values usually decline when crude oil prices rise, for example. So, the crude oil prices and USD currency value are inversely related. Therefore, the USD value fluctuates freely because oil prices fluctuate daily.

Economists are of the point of view that markets generally correct themselves frequently. Most major economies are generally dependent on floating exchanges because of little government intervention. These countries are popularly known as 'First World Countries'.

Flexible Exchange Rate

The flexible exchange rate is called pegged exchange rate system because of government intervention. The value of a currency is maintained either to certain currencies’ values–either collectively or individually–or to the reserves of gold and foreign currencies available in the given country.

Fixed Exchange Rate

China is probably the most famous example of fixed exchange regimes. A fixed-rate regime also used to exist under the former Soviet Union. It must be noted that the flexible exchange rate is not solely determined by market forces. If the foreign exchange market fluctuates widely, the central banks will have to sell or buy currency reserves.

Speculation

Money is an asset for every nation. Therefore, citizens of one country may hold reserves of foreign exchange from another country as an asset. Therefore, Indians will be more interested in the value of the USD if they think that the value of their own currency will fluctuate in the near future. When people hold foreign exchange to get a benefit from the changing values, the currency values are affected by it.

Interest rates

The difference in interest rates of different countries also plays a major role in the determination of the value of exchange rates. In order to get more returns, banks, MNCs, and affluent investors invest money around the globe. This also affects the exchange rates to a large extent for a country.

Exchange Rates in the Long Run

To make long-term predictions of the exchange rate, purchasing power parity or PPP can be used in an exchange rate structure that is flexible. According to theory, if a business does not have any frontier to cross such as quotas (quantitative controls on imports), and taxation (tariffs on business), then exchange rates will gradually adjust so that the same products cost the same price regardless of location.

Therefore, whether one is transferring it into rupees in India, yen in Japan, or dollars in the US, the value of the currency must be the same in terms of exchange rates.

Pegged Floating Exchange Rates

There are three hybrid domains in this system. Governments and Central Banks are capable of controlling foreign exchange rates by intervening in the markets. However, the rates are mostly determined by existing market forces.

Crawling Bands

In such a regime, the central bank allows fluctuations in a currency exchange rate until a specific range that is usually set in advance is reached. The authorities intervene in the system once the range is breached. These ranges are generally determined by monetary and economic policies.

Crawling Pegs

In this system, the Central Bank of a country allows its currency exchange rate to appreciate or depreciate gradually on international markets. The currency will float if there are any market uncertainties. However, the authorities will interfere if appreciations or depreciations are swiftly followed by one another. Such instances have already happened in Vietnam, Argentina, and Costa Rica.

Horizontally Pegged Bands

It resembles the crawling bands to some extent. In such a case, the Central Bank allows the currencies to fluctuate increasingly freely until the exchange rate does not go above 1% of the gross value of the currency.

Conclusion

Exchange rate determination is a very important part of macroeconomics. As the currency is the moving force of an economy, changes in its rates affect everyone. Therefore, governments try to increase the value of their currencies so that the balance of payments could be managed at a satisfactory level.

The balance of payment is the net difference between aggregated imports and net exports of a country. So, when exchange rates are high, less currency can buy more in the international markets. This helps countries to manage a good level of economic growth and, in turn, offers more value to their citizens.

FAQs

Q1. What is the major difference between flexible and floating exchange rates?

Ans. The flexible exchange rates are determined and fixed by the government or the central bank while the floating exchange rate is determined by the market forces of demand and supply. This is a major difference between flexible and fixed exchange rates.

Q2. Which exchange rate has minimum government intervention?

Ans. The floating exchange rates have the minimum government intervention.

Q3. How do interest rates impact the exchange rates of a country’s currency?

Ans. When interest rates are high in a country, investors and individuals invest more money in it. This increases the quantity of foreign reserves which makes the local currency stronger.