Exchange Rate: Concepts and Theories | UGC NET Economics – Notes

Introduction

• One of the key economic decisions a country takes is how it will value its currency in comparison to other currencies. An exchange rate regime is how a country manages its currency in the foreign exchange market. An exchange rate regime is closely related to the country’s monetary policy.

• A country can manage its currency in a foreign exchange market under three types of exchange rate regimes:

  • Floating exchange rate

  • Fixed exchange rate

  • Managed floating exchange rate

• A floating exchange rate regime is where the central bank determines the money supply and lets the exchange rate adjust freely according to market forces. In many countries, however, the central bank acts under implicit or explicit exchange rate target and uses monetary policy to achieve those targets. This type of exchange rate arrangement is called the fixed exchange rate regime. There is another type, i.e., managed floating, where the central bank influences the exchange rate without having a specific exchange rate path or target. Central to the decision of whether to buy domestic goods or foreign goods is the price of domestic goods relative to foreign goods, that is, the exchange rate.

• An exchange rate is the specific value or price of one nation’s currency measured in terms of another country’s currency. It essentially determines your international purchasing power by dictating exactly how much of a foreign currency you will receive in exchange for a single unit of your home currency. Currencies are always quoted in pairs, such as USD/EUR, where the first currency serves as the base asset and the second represents the quoted price. These rates directly impact the cost of international travel, the pricing of imported retail goods, and the profitability of global business investments.

• In the global financial system, exchange rates generally operate under either a floating or a fixed framework.

  • Most major global currencies use a floating system, meaning their values fluctuate continuously based on the real-time supply and demand dynamics of the foreign exchange market.

  • This market demand is heavily driven by shifting economic factors, including central bank interest rates, national inflation percentages, political stability, and overall gross domestic product (GDP) growth.

  • Conversely, some countries utilize a fixed or pegged exchange rate system, where the government or central bank artificially binds their currency’s value to a stable asset, like the US Dollar or gold, to prevent drastic market volatility.

Concepts

• It is important to understand terms such as foreign exchange, exchange rate, and exchange rate regime as they are central to understanding the economy around.

• Foreign Exchange: Foreign exchange refers to money denominated in a currency other than the domestic currency. Foreign exchange can be cash, funds available on credit cards and debit cards, and bank deposits.

• Exchange rate: The exchange rate is the rate at which a currency of one country exchanges for another country’s currency. The exchange rate can either be expressed:

  • In terms of the number of units of domestic currency per unit of foreign currency (direct quotation) as in the case of most currencies such as the Indian rupee. For example, if the exchange rate between the rupee and the US dollar (USD) is quoted as Rs.65, this means that Rs.65 is required to purchase US$1.00.

  • Or in terms of the number of units of foreign currency per unit of domestic currency (indirect quotation) as in the case of some major trading currencies such as the pound sterling and the Australian dollar.

  • When the value of the domestic currency increases in terms of another currency, it is referred to as a nominal appreciation of the domestic currency.

  • In contrast, a decrease in the value of the domestic currency in terms of a foreign currency is known as nominal depreciation.

• Exchange rate regime: An exchange rate regime is the process by which a country manages its currency with respect to foreign currencies. Exchange rate regimes can broadly be categorized into two extremes:

  • Fixed

  • Floating

  • Between these, there are several combinations of the two. The exchange rate system refers to the arrangement for the movement of the exchange rate. Countries in the world operate under different exchange rate regimes.