Basics of Exchange Rates

The rate at which a currency is exchanged for another is known as an exchange rate. It is the price of one currency expressed in another currency. So if you have $1 and you can buy ¥100 for that, then the exchange rate is USD/JPY = 100.

Types of Exchange Rate Systems
Fully Fixed Exchange Rates: Under this system, the government or the central bank of a country intervenes in the forex market and keeps the exchange rate of the nation’s currency fixed against currencies of other nations. In doing so, the government prevents any major fluctuation of the currency from the fixed rate.

Semi-Fixed Exchange Rates: Under this system, economic policy making revolves around the exchange rate. The currency is permitted to fluctuate within a range and interest rates are revised to influence the currency into meeting the targeted exchange rate.

Free Floating Exchange Rates: Under this system, no organization or body intervenes in the forex market. The exchange rate is determined by the market forces of supply and demand. Thus, under this system, exchange rates are dependent on trade flows and capital flows.

Managed Floating Exchange Rates: Rarely does a country follow a purely free floating exchange rate system. Extreme currency fluctuations may force a government to intervene through changes in interest rates and other means in order to stabilize the currency.

Fixed exchange rates provide greater business security to exporters and importers. On the other hand, free floating exchange rates prove beneficial to countries with a large balance of payments deficit, since automatic adjustments take place with exchange rate fluctuations. Moreover, with free floating exchange rates, a country’s interest rates can be set independent of currency movements