If you have to travel outside the country or purchase goods online from companies based outside your country, you will need foreign currency. You may need to understand exchange rates and how your money is converted into other currencies.
An exchange rate is a rate at which one country’s currency can be traded for another country’s currency. They exist so governments and firms can do business and pay in the appropriate currency.
Determination of Exchange Rates
There are several different ways an exchange rate for a currency can be set. They are:
- Floating (or Flexible) Exchange Rate,
- Fixed Exchange Rate, or
- Managed Float
Floating Exchange Rate
With a floating (flexible) exchange rate, the forces of supply and demand determine the rate at which two currencies will be exchanged. Let us assume that the domestic currency is INR (Indian Rupee), and all other currencies are foreign. If foreigners want to buy more goods and services from India or make investments in India, they must buy more INR to pay Indian suppliers for their purchases.
Therefore, when the rest of the world’s demand for Indian goods and services increases, the need for INR also increases. This increase in demand for the dollar will increase the rupee’s value in the foreign exchange market. As a result, the price of INR in other currencies will rise or appreciate. For example, if the price of 1 INR in USD is 0.15, when the demand for INR increases, the price of 1 INR might go up to USD 0.20.
In a floating exchange rate system, the free market forces of demand and supply regulate the currency’s market price until the equilibrium exchange rate is reached.
Because of this reliance on the market forces, floating exchange rates can fluctuate to extreme exchange rates in the short term. These excessive rates are inefficient and dangerous to the economy, but the floating exchange rate mechanism will correct these extreme positions toward the long-term equilibrium rate.
Essential Points in Floating Rate System
- The exchange rate is the price of one country’s currency stated in terms of another’s.
- When the INR appreciates, import prices fall in India, and the price of India’s exports to other nations rises.
- When the INR depreciates, import prices rise in India, and export prices fall.
- Foreigners’ demand for the INR reflects their demand for Indian products and investments in India.
- The supply of INR to foreigners by Indian citizens reflects Indian demand for foreign goods and services and foreign investments.
- At the equilibrium exchange rate, the INR demanded (purchased) equals those supplied (sold). Therefore, the INR value of the goods and services bought by foreigners and sold by Indian citizens will be equal.
Fixed Exchange Rate
Fixed exchange rates are rates set by some outside force, usually a governmental body such as the country’s central bank. The gold standard is one example of a fixed exchange rate. Under the gold standard, every country determines the value of its currency in terms of a fixed amount of gold. Thus, the exchange rates of currencies are fixed between countries. This means that if we pay for goods or services with golden bars, there would never be an exchange rate difference between countries, and gold would be the only world currency, leading to no exchange rates because everyone uses one money.
The purpose is to keep the currency trading in a narrow band, which can also be referred to as a pegged rate. A significant reason for the devaluation of a country’s currency is to improve its balance of payments.
Essential Points in Fixed Exchange Rate System
- Under a fixed exchange rate, the government buys and sells its currency at the fixed rate it determines.
- An overvalued currency is an exchange rate held above the free market.
- When a government overvalues its currency, it will have a balance-of-payments deficit. It must run down its foreign currency reserves to maintain the high exchange rate. Eventually, its resources will run out, forcing it to devalue its currency by lowering the official exchange rate.
- An undervalued currency is a fixed exchange rate below free market value.
- When a government undervalues its currency, it will have a balance of payments surplus. It will accumulate foreign currency reserves. It may revalue its currency by increasing its exchange rate to avoid getting too much.
Managed Float Exchange Rate
A managed float stands between the free market and the fixed system, including elements of the floating and fixed exchange rates models. Under the managed float system, the market generally determines the exchange rates, but the government also sells and buys currency to influence the exchange rate. Though the government does not fix the exchange rate specifically, its actions can strongly affect the exchange rate.
Example of Managed Exchange Rate :
Assume a government lets the national currency exchange rate be set by free market forces of demand and supply. Initially, this country produces high-quality goods at a competitive price due to lower input costs than in other countries. As a result, other countries buy the goods and services of this country at the market rate. To some extent, the value of the national currency has been increased by foreigners’ demand for its currency for the nation’s services and goods.
Unfortunately for this country, the increased demand for its currency causes the price of its currency to rise. This results in an increased cost of its goods abroad. Because these goods become more expensive, some o foreign buyers will look elsewhere for cheap cheaper substitute goods. With this increase in the relative cost of the country’s production, the demand for its currency falls, and its exports again become cheaper.
The government of this country does not like the floating exchange rate and the cyclical impact on its domestic economy. To minimize these fluctuations, the government begins to begin up and sell its currency to keep the exchange rate within an acceptable range. The government’s involvement in managing its currency makes it a managed float system.
How Does Exchange Rate Work?
Now that we know what exchange rates are, the different types, and why they exist, let’s explore how they work and are used across countries.
When an American company purchases goods from an Indian company, it will often want to be paid in their currency, Indian Rupee. Why might you ask? The Japanese company most likely needs their currency to pay their workers and run operations inside India, where they are located. To complete the transaction, the American company will enter the foreign exchange market, a local currency market made up of many buyers and sellers open nearly 24 hours a day during the week.
How much will the American company pay to convert their dollars to the Indian rupee? The answer depends on when the American company is ready to pay. If they are prepared to pay today, they will use the spot exchange rate, which is the current exchange rate. However, if it is a transaction in the future, it may use the forward exchange rate, which refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific date.
Conclusion: Exchange Rate Impacts both Business and Individual
In summary, for firms or countries to do business or for you to travel abroad, an exchange rate exists that helps determine the rate at which one country’s currency can be traded for another country’s currency. These exchange rates can be fixed, flexible, or partially flexible. Fixed exchange rates do not fluctuate or change in a very narrow band. Adaptable and somewhat flexible exchange rates let the forces of supply and demand primarily determine the exchange rates. These can fluctuate daily.
When a country or firm wants to exchange its own money so it can pay a foreign business partner or vendor, it must enter into the foreign exchange market, which is a financial currency market made up of many buyers and sellers and is open almost 24 hours a day during the week.
A currency may be quoted or paid based on the spot exchange rate, which refers to the current exchange rate, or the forward exchange rate, which refers to an exchange rate quoted and traded today but for delivery and payment on a specific future date.
Understanding the exchange rates and conversion ratios across countries will help you decide whether a good or service may be a good deal in another country. Large international firms must constantly monitor these exchange rates with their key trading partners, which can mean large amounts of money saved or lost to their bottom line.
