Determination of the Exchange Rate – Meaning
Every nation has a distinct methodology to decide its currency’s exchange rate.. It can be decided via three methods which are : fixed exchange rate, managed floating exchange rate or pegged exchange rate, and flexible exchange rate.
Flexible Exchange Rate
This exchange rate is decided by the marketplace forces of demand and supply. It is also known as the floating exchange rate. As represented in the given figure, the exchange rate is decided where the demand curve converges with the supply curve, that is, at point e on the y-axis. Point q on the x-axis decides the quantity of US $ that has been demanded and supplied on exchange rate. In a fully flexible system, the Central banks do not interfere in the foreign exchange marketplace.
Speculation
Money, in any nation, is an asset. If Indians credit that the British pound would go high in value compared to that of the rupee, then they would want to hold pounds. Hence, the exchange rates also get impacted when people hold foreign exchange in the anticipation that they can accrue profits from the appreciation of the currency.
Exchange Rate and Interest Rates
Another aspect that is significant in deciding the exchange rate is the distinctive interest rates, that is, the difference between the interest rates between the nations. There are immense amounts of funds owned by banks, MNCs, and affluent individuals that move around the globe in search of the highest percentage interest rates.
Exchange Rates in the Long Run
The theory of PPP or purchasing power parity is utilised to make long-run anticipations regarding the exchange rates in a flexible exchange rate structure. Conforming to the theory, if there are no frontiers to the business like taxes (tariffs on business) and quotas (quantitative constraints on imports), then the exchange rates must gradually adapt so that the same products cost the same prices whether quantified in rupees in India, yen in Japan, or dollars in the US, except for the dissimilarities in terms of transportation.
The above-mentioned is the concept that is explained in detail about the Determination of the Exchange Rate for the class 12 students. To know more, stay tuned to our website.
FAQs
Flexible or floating exchange rates occur when the exchange rate is determined by the market forces of supply and demand. As the demand for a currency increases relative to supply, that currency will appreciate, whereas currencies in which the quantity supplied exceeds the quantity demanded will depreciate.
How are exchange rates determined in a flexible exchange rate system quizlet? ›
How are flexible exchange rates determined? The exchange rate is determined where the quantity of a currency demanded is equal to the quantity supplied of the currency. consumers in the country lose if they continue to pay a price higher than the world price for the good in question.
What determines a country with a flexible exchange rate? ›
A country with a flexible exchange rate determines the value of its currency based on: A . the supply and demand for the currency in global markets.
What is the determination of the exchange rate? ›
Determination of the Exchange Rate – Meaning
Every nation has a distinct methodology to decide its currency's exchange rate.. It can be decided via three methods which are : fixed exchange rate, managed floating exchange rate or pegged exchange rate, and flexible exchange rate.
How do exchange rates get determined? ›
How much demand there is in relation to the supply of a currency will determine that currency's value in relation to another currency. For example, if the demand for U.S. dollars by Europeans increases, the supply-demand relationship will cause an increase in the price of the U.S. dollar in relation to the euro.
How real exchange rate is determined? ›
The real exchange rate (RER) between two currencies is the product of the nominal exchange rate (the dollar cost of a euro, for example) and the ratio of prices between the two countries.
In which exchange rate system is the exchange rate determined? ›
A floating exchange rate is a regime where the currency price of a nation is set by the forex market based on supply and demand relative to other currencies. This is in contrast to a fixed exchange rate, in which the government entirely or predominantly determines the rate.
What is the flexible trade exchange rate What is it based on? ›
Floating or flexible rates
Flexible exchange rates: Supply and demand in the foreign exchange market determine the equilibrium exchange rate without central bank intervention.
What does a flexible exchange rate system allow? ›
Flexible exchange rates have the advantage that they allow a country to pursue an independent monetary policy, rather than have its own monetary policy set by an anchor currency country.
What are the three factors that determine exchange rates? ›
Here's a beginner's guide to the factors that influence changes in exchange rates.
- Exchange rates are affected by supply and demand. ...
- Exchange rates are affected by interest and inflation rates. ...
- Exchange rates are affected by balance of trade deficits. ...
- Exchange rates are affected by government debt.
A flexible exchange rate system provides the government with more flexibility, and it does not need to perpetuate large stocks of foreign exchange reserves. The vital merit of flexible exchange rates is that movements in the exchange rate instinctively takes care of the deficits and surpluses in the balance of payment.
Does the US use a flexible exchange rate? ›
There are two types of currency exchange rates—floating and fixed. The U.S. dollar and other major currencies are floating currencies—their values change according to how the currency trades on forex markets. Fixed currencies derive value by being fixed or pegged to another currency.
How is exchange rate determined in fixed exchange rate? ›
A fixed exchange rate is a regime imposed by a government or central bank which ties the official exchange rate of the country's currency with the currency of another country or the gold price.
How are fixed flexible and managed exchange rates determined? ›
Determination: Fixed exchange rates are determined by government or central bank intervention, while flexible exchange rates are determined by market forces.
How exchange rate is determined under free exchange rate system? ›
In a free-floating exchange rate system, exchange rates are determined by demand and supply. Exchange rates are determined by demand and supply in a managed float system, but governments intervene as buyers or sellers of currencies in an effort to influence exchange rates.
