Exchange Rate Determination

Known worldwide for their public meetings of international figures in trade and commerce, the Bretton-Woods Conference, the Louvre Agreement and the Smithsonian Agreement addressed complicated subjects like exchange rates.

The exchange rates of different currencies are fixed differently by different countries in a liberalized and globalized world. An exchange rate is decided by a nation's policy in a free market. 

In commerce, advanced students need to understand exchange rates and how they fluctuate every day, and sometimes even hourly. It is determined by the exchange rate how many units of one currency can be exchanged for another currency.

There is no single and universal currency in our globalized world despite free and fair trade agreements. All countries dealing in the sale and purchase of goods and services encounter this stumbling block. It wasn't until the second half of the 20th century, after the Second World War, that exchange rates were introduced.

Intercountry trade grew rapidly, and financial mechanisms were modified accordingly.

How Exchange Rates are Determined

To determine its currency's exchange rate, every country has its own methodology. Several methods can be used to decide the exchange rate, including fixed exchange rate, managed floating exchange rate, and flexible exchange rate.

Flexible Exchange Rate

It is sometimes referred to as a pegged exchange rate system since governments tend to keep an eye on exchange rates. The currency value is pegged either to certain currencies- either individually or collectively- or to its reserves of gold and foreign currencies.

As far as fixed exchange regimes are concerned, China is probably the most famous example. There was also a fixed rate regime under the former Soviet Union. The exchange rate is not solely determined by market forces under this regime. When the foreign exchange market fluctuates widely, the central banks will sell or buy reserves.

Floating Exchange Rate

An exchange rate that fluctuates or is flexible is called a floating exchange rate. The market determines whether it moves or not. The term "floating currency" refers to any currency subject to a floating regime. The US dollar is an example of a floating exchange currency.

Floating exchange rates are popular among economists. Those who believe in a free market believe that currency value should be determined by the market. USD prices tend to decline when crude oil prices rise, for example. The two are inversely related.

The USD value fluctuates freely since oil prices vary daily.

Economists claim that markets correct themselves frequently. Most major economies are largely dependent on floating exchanges thanks to little government intervention. In popular parlance, these are countries commonly called 'First World Countries'.

Speculation

Every nation has money as an asset. Indians will care more about the British pound's value than they would about the rupees if they believe the rupee will go up in value. As a result, when people hold foreign exchange hoping to reap the benefits of rising currency values, the exchange rates are also affected.

Exchange Rate and Interest Rates

Furthermore, the difference between interest rates between nations plays a role in determining the exchange rate. In search of the highest percentage interest rate, banks, MNCs, and affluent individuals move billions of dollars around the globe.

Exchange Rates in the Long Run

Purchasing power parity or PPP can be used to make long-term predictions on the exchange rate in an exchange rate structure which is flexible. As per the theory, if a business has no frontiers to cross such as taxation (tariffs on business) and quotas (quantitative controls on imports), then exchange rates must gradually adjust so that the same products cost the same price regardless of whether you're translating into rupees in India, yen in Japan, or dollars in the US, apart from the different modes of transportation.

Pegged Float Exchange Rate

There are three hybrid regimes in this system. Governments and Central Banks can control foreign exchange rates by intervening in the markets. However, exchange rates are mostly determined by existing market forces.

There are 3 types:

Crawling Bands:

A central bank will allow fluctuations in a currency until a specific range that is usually set in advance. The authorities will intervene once the range is breached. These ranges are determined by monetary and economic policies.

Crawling Pegs:

As a result of the system, the Central Bank allows its currency to appreciate or depreciate gradually on international markets. The currency will have the capability to float if there are any market uncertainties. However, the authorities will intervene if appreciation or depreciation are swiftly followed by one another. This has already happened in Argentina, Vietnam, and Costa Rica.

Horizontally Pegged Bands:

It resembles crawling bands a bit. Nevertheless, Central Banks allow their currencies to fluctuate much more freely, provided that the exchange rate does not exceed 1% of the gross value of its currency.