What is
foreign exchange? What is foreign exchange rate? In the business world,
especially an international one, the use foreign exchange is quite frequent,
and it is necessary for them to be updated on the latest news of these
exchanges as their whole finance depends on this. So, what is it?
Foreign
exchange is the currency of all the other countries except for your own. The
money or legal tenders that the other country deals in is known as the foreign
exchange and in order to make a payment to that country, you will have to
exchange your currency with theirs. For instance, India’s currency is rupee but
all the other currency like US Dollar, UK Pound and more will be the foreign
exchange for us.
Foreign
exchange rate is basically the rate at which you are exchanging one currency
for another. Meaning, the price of one currency in respect of other. For
instance, 1 US Dollar in India is of 70 rupees therefore, in India, the price
of US Dollar is 70 rupees.
But how do
we decide this rate and who is responsible for the fluctuations in these rates?
How does the exchange rate system work? Well, there are three different systems
that deals with the foreign exchange rate with different rules in each of them.
Let’s study them in detail.
FIXED
EXCHANGE RATE SYSTEM
In this
system, the rate of a currency is fixed by the government and no one else is
allowed to interfere in their decision. The basic purpose of this system is to
maintain stability in the rates. To maintain the rate fixed by the them, they
buy the foreign currencies when the exchange rate is less and sells them off
when the rate increases. For this, the government must maintain a large reserve
with them so that they can buy the currencies whenever they desire.
Also, in
this system, each country fixes their currency value in the terms of an
‘external standard’. This external currency can be anything, from gold to
silver to any other country’s currency.
FLEXIBLE
EXCHANGE RATE SYSTEM
Under this
system, the exchange rate is set by the forces of demand and supply of the
foreign exchange in the market. This system is also known as ‘floating exchange
rate’. There is no government, or any other authority involved here to make a
decision on the price of the foreign exchange. Therefore, the value of the currency
fluctuates a lot in this system. The demand and supply of the currency in the
market is affected by the interaction of thousand of associations like the
banks, firms and others who buy and sell these currencies on a regular basis.
MANAGED
FLOATING RATE SYSTEM
This is a
system which is a combination of both the above systems. Here, the exchange
rate is set by the market forces of demand and supply as well as the central
bank influence on the prices through the intervention in the market. This system
is also known as ‘dirty floating’. The central bank intervenes in the foreign
exchange market to restrict the rates being fluctuated vastly. The aim is to
keep the rates close to the targeted prices.
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