Exchange rate or foreign exchange rate is the rate at which one currency is exchanged for another. It is the price at which one currency is traded for another.
Currencies can be bought and sold at foreign exchange market, just like any other commodity is traded at the market. This is necessary because we need foreign currency to do trade with other countries. Countries do international trade because no country can produce everything it needs.
For example, Bank of Maldives currently sells Maldivian Rufiyaa at MRF15.42 per US$.
Floating Exchange rate system
If a country has a floating exchange rate system, the value of the currency is determined freely by the forces of demand and supply. However, the government can still try to stabilize its currency by buying and selling foreign currencies thereby affecting demand and supply. But it is still the forces of the market which determines the exchange rate.
When the value of the local currency goes down in a floating exchange rate system, it is known as a depreciation. An increase in the value of the local currency in a floating exchange rate system is known as an appreciation.
- Changes in the balance of trade.
A sustained balance of trade deficit over the years will lead to depreciation of the currency because more currency needs to be supplied to pay for the imports while the currency earned from the exports are not able to match that of the leakage due to imports.
- The changes in interest rates.
If the local interest rates are higher, people will be encouraged to save more at the banks. This will take money out of the circulation. Furthermore, foreigners too maybe keen to save and invest in local banks. This could lead to the appreciation of the local currency.
Speculators try to gain profit from predicting what might happen to the value of the money in the future. Speculation itself affects the value of the currency. For example, if speculators think that the price of US$ in terms of MRF will go up in the future, they will try to buy more US$ and hold whatever US$ they have. This actually creates a still higher demand for US Dollars.
- The price of imported raw materials and essential goods
When the prices of raw materials such as construction materials and essential commodities like oil and food products goes up, the demand for foreign currencies goes up. This leads to a depreciation of the local currency.
Fixed Exchange rate system
In a fixed exchange rate system, a country pegs the local currency to a foreign currency or a basket of currencies. This is also called a ‘pegged’ exchange rate system. Until very recently, Maldives had a fixed exchange rate system.
A country may adopt this system to avoid the uncertainty created by the free floating system.
To adopt this kind of a system, the central bank holds an exchange equalization account to buy and sell foreign currency in order to compensate for the excess demand and supply.
When the central bank raises the value of the currency, it is known as a ‘revaluation’. When the central bank lowers the value of the local currency, it is known as‘devaluation’.
A managed floating rate systems is a hybrid of a fixed exchange rate and a free floating exchange rate system. In a country with a managed floating exchange rate system, the central bank becomes a key participant in the foreign exchange market.
Unlike in a fixed exchange rate regime, the central bank does not have an explicit set value for the currency; however, unlike in a floating exchange rate regime, it doesn’t allow the market to freely determine the value of the currency.
Instead, the central bank has either an implicit target value or an explicit range of target values for their currency: it intervenes in the foreign exchange market by buying and selling domestic and foreign currency to keep the exchange rate close to this desired implicit value or within the desired target values.
Example: Suppose that Thailand had a managed floating rate system and that the Thai central bank wants to keep the value of the Baht close to 30 Baht/$. In a managed floating regime, the Thai central bank is willing to tolerate small fluctuations in the exchange rate (say from 28.75 to 34.25) without getting involved in the market.
If, however, there is excess demand for Baht in the rest of the market causing appreciation below the 24.75 level the Central Bank increases the supply of Baht by selling Baht for dollars and acquiring holdings of U.S dollars. Similarly if there is excess supply of Baht causing depreciation above the 25.25 level, the Central Bank increases the demand for Baht by exchanging dollars for Baht and running down its holdings of U.S dollars.
So, under a managed floating system, the central bank holds stocks of foreign currency: these holdings are known as foreign exchange reserves. It is important to realize that a managed ﬂoat can only work when the implicit target is close to the equilibrium rate that would prevail in the absence of central bank intervention. Otherwise, the central bank will deplete its foreign exchange reserves and the country will soon be in a free floating exchange rate system because they can no longer intervene.
Some managed floating regimes use an explicit range of target values instead of using an implicit range of values. For example, in the early 1990s, many European countries participated in an arrangement called the “Exchange Rate Mechanism” (ERM) in which they set a range of values (a band that was 2.25 percentage points wide on either side of a central value) in which their currencies were free to move in but agreed to intervene to prevent currencies from moving outside that range.
Maldives currently has a managed floating system in which MRF is allowed to float within such a band.
Next Topic: International Trade