An exchange rate is the price of one currency in terms of another currency. As in the case of any other goods, the price of a currency is affected by supply and demand. As demand for a currency increases (or supply decreases) its price will rise. This is referred as an appreciation. Conversely, as demand for a currency decreases, or supply increases, its value will depreciate. The prospect of large and rapid swings in exchange rates introduces uncertainty into the business environment. A well-functioning international monetary system ensures stability in the exchange rates. The central element of the international monetary system involves the arrangements by which exchange rates are set. The purpose of an exchange-rate system is to facilitate and promote international trade and finance. There have been three major exchange rate regimes from a historical perspective — Fixed Exchange Rates, Floating or Flexible Exchange Rates, and Managed Exchange Continue reading
Exchange Rate System
Important International Finance Terms
1) Gold Bullion Standard: The basis of money remains a fixed weight of gold but the currency in circulation consist of paper notes with the authorities standing ready to convert unlimited amounts of paper currency in to gold and vice-versa, on demand at a fixed conversion ratio. Thus a pound sterling note can be exchanged for say ‘x’ ounces of gold while a dollar note can be converted into say ‘y’ ounces of gold on demand. 2) Gold Exchange Standard: Gold Exchange Standard was established in order to create additional liquidity in the international markets. Hence the some of the countries committed themselves to convert their currencies into the currency of some other country on the gold standard rather than into gold. The authorities were ready to convert at a fixed rate, the paper currency issued by them into the paper currency of another country, which is operating a gold Continue reading
Impact of Foreign Exchange Rate on Balance of Payments (BOP)
The International Monetary Fund (IMF) defines the Balance of Payments (BOP) as a statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world. BOP data measures economic transactions include exports and imports of goods and services, income flows, capital flows, and gifts and similar one-sided transfer payments. The net of all these transactions is matched by a change in the country‘s international monetary reserves. The significance of a deficit or surplus in the BOP has changed since the advent of floating exchange rates. Traditionally, BOP measures were used as evidence of pressure on a country‘s foreign exchange rate. This pressure led to governmental transactions that were compensatory in nature, forced on the government by its need to settle the deficit or face a devaluation. Impact of Foreign Exchange Rate on Balance of Payments (BOP) The relationship between the Continue reading
Floating or Flexible Exchange Rate System
A floating or flexible exchange rate system is one in which the exchange rate between currencies is determined purely by supply and demand of the currencies without any government intervention. The rates depend on the flow of money between the countries, which may either result due to international trade in goods or services, or due to purely financial flows. Hence in case of a deficit or surplus in the balance of payments, the exchange rates get automatically adjusted and this leads to a correction of the imbalance. In a floating exchange rate system, economic parameters like price level changes, interest differentials, economic growth and government policies have an impact on the exchange rate as these factors influence the supply and demand of currencies. A purely floating exchange rate system is more of a theoretical benchmark rather than reality in practice. Most economies fall in between the two extremes — a Continue reading
Reasons for Divergences Between De facto and De jure Exchange Rate Policies
The first reason for the divergences between de facto and de jure exchange rate policies is that, de facto exchange rate stability is just an incidental side effect of a monetary policy strategy in which the exchange rate is only one of the many variables that the central bank monitors and reacts to. This is as; whatever decision of the authorities of the country that is being made in turn will have an effect on the pricing of its goods and services, economic wellbeing of the country and also its exchange rate. The second reason to it is that, the central bank thinks that the economy will occasionally be affected by idiosyncratic shocks that will require significant exchange rate adjustments. This means that the central bank does not want the exchange rate to be tied by a previous commitment that might make the adjustments more difficult to be carried out. Continue reading
Global Scenario of Exchange Rate Arrangements
Firms engaged in international business must have an idea about the exchange rate arrangement prevailing in different countries as this will facilitate their financial decisions. In this context, it can be said that over a couple of decades, the choice of the member countries has been found shifting from one form of exchange rate arrangement to the other, but, on the whole, preference for the floating rate regime is quite evident. At present as many as 35 of a total of 187 countries have an independent float, while the other 51 countries have managed floating system. The other 7 countries have a crawling peg, while 53 countries have pegs of different kinds. The EMU and other 20 countries of Africa and the Caribbean region come under some kind of economic and monetary integration scheme in which they have a common currency. Lastly, nine countries do not have their own currency Continue reading