Exchange rate
Exchange rate is the value at which one currency can be exchanged for another. It is a crucial aspect of the global economy, influencing international trade, investment, and travel. Exchange rates can be classified into two main types: fixed and floating. In a Fixed exchange rate system, a country's currency value is tied to another single currency or a basket of other currencies, or another measure of value, such as gold. A Floating exchange rate, on the other hand, is determined by the private market through supply and demand.
Types of Exchange Rates[edit | edit source]
There are several different ways to classify exchange rates:
- Fixed Exchange Rate: A system where the currency's value is fixed against the value of another currency, a basket of other currencies, or another measure of value, such as gold.
- Floating Exchange Rate: Also known as a fluctuating exchange rate, this is determined by the private market through supply and demand.
- Managed Float: Also known as a dirty float, this occurs when government monetary authorities intervene in the foreign exchange market to stabilize or influence the currency value.
- Pegged Float: In this system, the currency's value is pegged to another currency or a basket of currencies but can fluctuate within a narrow margin.
Factors Influencing Exchange Rates[edit | edit source]
Several factors can influence exchange rates, including:
- Interest Rates: Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise.
- Inflation Rates: A country with a lower inflation rate than another's will see an appreciation in the value of its currency.
- Current-Account Deficits: The balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest, and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning.
- Public Debt: Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. This can prompt inflation. If a government's debt is financed by selling debt to foreign investors, this can also lead to a decrease in the value of its currency.
- Political Stability and Economic Performance: Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk.
Exchange Rate Regimes[edit | edit source]
The choice of exchange rate regime can affect a country's economic stability. The main regimes include:
- Dollarization: This occurs when a country decides not to issue its own currency and adopts a foreign currency as its national currency.
- Currency Board Arrangements: Under this system, a country's currency is backed 100% by foreign currency reserves, aiming to keep the exchange rate stable.
- Conventional Fixed Peg Arrangements: The country pegs its currency at a fixed rate to another currency or a basket of currencies, where the exchange rate fluctuates within a narrow margin of at most ±1% around a central rate.
- Crawling Pegs and Bands: The currency is adjusted periodically at a fixed, preannounced rate or in response to changes in selective quantitative indicators.
Impact of Exchange Rates[edit | edit source]
Exchange rates have a profound impact on a country's economy, affecting everything from the price of goods and services to the health of the nation's economy. They can influence inflation, exports, imports, and even interest rates. A strong currency makes a country's exports more expensive and imports cheaper in foreign markets; a weak currency does the opposite.
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Contributors: Prab R. Tumpati, MD