Exchange Rates

Exchange Rates are used to describe or denote the currency of one country with respect to the currency of another country. It is the rate at which the currencies can be exchanged. An exchange rate of 0.63 British pounds to one Australian dollar means that 1 AUD is equal to 0.63 British pounds. Exchange rates are also known by the names of foreign exchange rate and Forex rate. For the calculation or conversion of exchange rates, exchange rate calculators are used. These applications convert the input currency to the desired equivalent currency.

Rates of Exchange can be classified into three categories

Fixed Exchange Rate

Fixed rate, also known as pegged rate, is the rate which is set by the central bank of the country. The central bank pegs the local currency with any strong currency like dollars, euros or pounds. All of the exchange transactions are carried out under the same rate maintained by the central bank. It is the responsibility of the central bank to maintain the local exchange rates. Local currency keeps on fluctuating with the strong or pegged currency.

Advantages:
• Prices of exports and imports of the country do not change rapidly as the exchange rate is fixed. That way the terms of trade remain fairly stable.
• Economic fluctuations in the international market do not adversely affect the country which adopts the fixed rate system.

Disadvantages:
There is no automatic mechanism which can adjust the changes in the demand and supply of the currency.

Floating exchange rate

A Floating exchange rate is determined by supply and demand. Any difference in the supply and demand will automatically be fixed. Capital and trade inflows and outflows are the determinants of the exchange rate in this system. A floating exchange rate without the intervention of government or a central bank can rarely exist. The central bank has to take steps to control the exchange rate in the market.

The demand for foreign exchange depends upon the demand for the imports of that particular country. For example, if the demand of Australian imports is very high, ultimately the demand for Australian dollar will rise.

Advantages of a floating exchange rate system:
The main advantage of the floating exchange rate system is that it can automatically adjust any difference in the supply and demand of the currency. If the country’s demand for imports is stronger than the supply of its exports the demand will automatically rise and vice versa.

Disadvantages:
• This system leads to inflation, which has to be controlled by the central bank by changing interest rates.
• The exchange rate keeps on changing and consequently the prices of exports and imports in the country change accordingly.

Managed floating exchange rate

With a managed floating rate, the currency is not allowed to freely float in the international market. Instead the central bank of the country manages the exchange rate itself. The central bank calculates the average of the value of the currencies of its trading countries using exchange rate calculator and then manages the local currency.

Quoted price

When using a quoted price or quotation, one currency is set as the base and the other is quoted currency. For instance, a quotation of AUD/USD is 0.99 indicates that 0.99USD per AUD. USD is the quote currency and AUD is the base currency. Base and quote currencies are determined by markets.

Direct quoted price:
In direct quote prices, the home country uses its own currency as the quote currency. In Australia, 1.34AUD = 1EUR denotes the direct quoted price.

Indirect quoted price:
When the home country uses its own currency as the base currency it is said to be indirect quotation. In Australia, 1AUD = 0.75EUR is an indirect quotation.

Changes in exchange rates

In the international market, the exchange rate keeps on fluctuating. When the demand of currency in a market increases more than its supply, the currency will become worth more. Similarly, when demand is less than supply the currency will be worth less. The central bank of the country keeps an eye on the exchange rate and is responsible for fixing it. The central bank tracks exchange rate changes using exchange rate calculator. The central bank can adjust the demand and supply of currency in the international market with the help of trades, GDP, maintaining the employment level in the country, and adjusting the interest rates.

Most countries devalue their currency in the international market to gain trade and inflow of payments. By devaluing the currency, the goods of the local country become cheaper in the international market. Devaluing the currency for long periods is extremely detrimental to the economy of the country.

Factors affecting exchange rate

One of the biggest drivers of the exchange rate is interest rate. Any change in the interest rate directly changes the exchange rate. Some other major factors which affect the exchange rate include:

• Financial stability of the country
• Policies of the central bank
• Equity and trade flows
• Foreign investments