Exchange rate is used to describe or denote the currency of one country with respect to the currency of another country. It is the rate on which the currencies can be exchanged. Exchange rate of 0.63 British pounds to Australian dollar means that 1 AUD is equal to 0.63 British pounds. The value or worth of 1 AUD and 0.63 British pounds is same. Exchange rates are also known by the names of foreign exchange rate and Forex rate.
Forex rate can be classified into three categories.
Fixed rate:Fixed rate also known as pegged rate, is the rate which is set by the central bank of the country. The central bank pegs the local currency with any strong currency like dollar, euro or pound. All the exchange transactions are carried out under the same rate maintained by the central bank. It is the responsibility of the central bank to maintain the local exchange rates. Local currency keeps on fluctuating with the strong or pegged currency.
Advantages:
- Prices of exports and imports of the country do not change rapidly as the exchange rate is fixed. Thus terms of trade remain fairly stable.
- Economic fluctuations in the international market do not adversely affect the country which adopts the fixed rate system.
Disadvantages:
There is no automatic mechanism which can adjust the changes in the demand and supply of the currency.
Floating rate:
Floating exchange rate is determined by the market forces of supply and demand. Any difference in the supply and demand will automatically be fixed. Capital and trade inflows and outflows are the determinants of the exchange rate in this system. A floating exchange rate without the intervention of government or central bank can rarely exist. Central bank has to take steps to control the exchange rate in the market.
The demand for foreign exchange depends upon the demand for the imports of that particular country. For example, demand of Australian imports is very high, ultimately the demand for Australian dollar will rise.
Advantages of floating rate system:
The main advantage of the floating exchange rate system is that it can automatically adjust any difference in the supply and demand of the currency. If the country's demand for imports is stronger than the supply of its exports the demand will automatically rise and vice versa.
Disadvantages:
- This system leads to inflation, which has to be controlled by the central bank by changing interest rates.
- The rate keeps on changing, consequently prices of exports and imports of the country changes accordingly.
Managed floating rate:
In managed floating rate, the currency is not allowed to freely float in the international market rather the central bank of the country manages the forex rate itself. The central bank calculates the average of the value of the currencies of its trading countries using exchange rate calculator and then manages the local currency.
Quoted price:
In quoted price or quotation, one currency is set as the base and the other is quoted currency. For instance, a quotation of AUD/USD is 0.99 indicates that 0.99USD per AUD. USD is the quote currency and AUD is the base currency. Base and quote currencies are determined by markets.
Direct quoted price:
In direct quote prices, the home country uses its own currency as the quote currency. In Australia, 1.34AUD = 1EUR denotes direct quoted price.
Indirect quoted price:
When the home country uses its own currency as the base currency it is said to be indirect quotation. In Australia, 1AUD = 0.75EUR is an indirect quotation.
Changes in exchange rates:
In international market, forex rate keeps on fluctuating. When the demand of currency in market increases than its supply, the currency will become more worthy. Similarly, when demand is less than supply the currency will be less worthy. The central bank of the country keeps an eye on the exchange rate and is responsible for fixing it. Central bank can adjust demand and supply of currency in the international market with the help of trades, GDP, maintaining the employment level in the country and adjusting the interest rates.
Most countries devalue their currency in the international market to gain trade and inflow of payments. By devaluing the currency, the goods of the local country become cheaper in the international market. Devaluing the currency for longer periods is suicidal for the economy of the country.
Factors affecting forex rates:
The most major driver of the exchange rate is interest rate. Any change in the interest rate directly changes the forex rate. Some major factors which affect the exchange rate include:
- Financial stability of the country
- Policies of the central bank
- Equity and trade flows
- Foreign investments
