An exchange rate is the price of one currency in terms of another currency. As in the case of any other goods, the price of a currency is affected by supply and demand. As demand for a currency increases (or supply decreases) its price will rise. This is referred as an appreciation. Conversely, as demand for a currency decreases, or supply increases, its value will depreciate. The prospect of large and rapid swings in exchange rates introduces uncertainty into the business environment. A well-functioning international monetary system ensures stability in the exchange rates. The central element of the international monetary system involves the arrangements by which exchange rates are set.… Read the rest
Exchange Rate System
European Monetary System
After the break down of the Bretton Woods System in 1973, several European countries attempted various mechanisms to fix their exchange rates to each other. While allowing their currencies to float against the dollar, these European countries tried progressively to narrow the extent to which they let their currencies fluctuate against each other. Six members of the European Economic Community (EEC), including France and Germany, jointly floated their currencies against the dollar. The currencies of the participating countries were allowed to fluctuate in a narrow band with respect to each other (1.125% on either side of the parity exchange rate), and the permissible joint float against other currencies was also limited (to 2.5% on either side of the parity).… Read the rest
Floating or Flexible Exchange Rate System
A floating or flexible exchange rate system is one in which the exchange rate between currencies is determined purely by supply and demand of the currencies without any government intervention. The rates depend on the flow of money between the countries, which may either result due to international trade in goods or services, or due to purely financial flows. Hence in case of a deficit or surplus in the balance of payments, the exchange rates get automatically adjusted and this leads to a correction of the imbalance.
In a floating exchange rate system, economic parameters like price level changes, interest differentials, economic growth and government policies have an impact on the exchange rate as these factors influence the supply and demand of currencies.… Read the rest
Fixed Exchange Rate System
A fixed (or pegged) exchange rate system is one where governments or central banks set official exchange rates and defend the set rates through foreign exchange market intervention and monetary polices. Under this system, the currency is pegged to another currency (or basket of currencies) and the central bank promises to exchange currency at a specified rate against the other currency. Each central bank actively buys or sells its currency in foreign exchange market whenever its exchange rate threatens to deviate from its stated par value by more than an agreed-upon percentage.
For example, India pegs its Rupee to the U.S.… Read the rest
Important International Finance Terms
1) Gold Bullion Standard:
The basis of money remains a fixed weight of gold but the currency in circulation consist of paper notes with the authorities standing ready to convert unlimited amounts of paper currency in to gold and vice-versa, on demand at a fixed conversion ratio. Thus a pound sterling note can be exchanged for say ‘x’ ounces of gold while a dollar note can be converted into say ‘y’ ounces of gold on demand.
2) Gold Exchange Standard:
Gold Exchange Standard was established in order to create additional liquidity in the international markets. Hence the some of the countries committed themselves to convert their currencies into the currency of some other country on the gold standard rather than into gold.… Read the rest
Rate of Exchange under different Monetary Standards
The term ‘rate of exchange’ expresses the price of one currency in terms of another. Thus, it indicates the exchange ratio between the currencies of two countries. Suppose for example, one Indian Rupee is equal to 13 USA Cents. This implies that in the exchange market, one Indian Rupee will fetch 13 Cents. Just as the price of a commodity is determined by its demand and supply conditions, the price of a foreign currency (i.e., the rate of an exchange) is also determined on the basis of demand and supply of the currency. In fact, the rate of exchange of a currency will keep on changing in the foreign exchange market, due to changes in demand and supply conditions of the currency.… Read the rest