Exchange Rate Determination

In a liberalised and globalised world, various countries employ different methods to fix their currency’s exchange rates. The determination of the exchange rate in a free market is a nation’s private policy. 

As advanced students of commerce, you must be aware of exchange rates and how they fluctuate daily, and sometimes even hourly. An exchange rate determines how many units of one currency can be exchanged in lieu of another currency.

Despite a globalised world with free and fair trade agreements, there is no single and universal currency. It is a stumbling block for all nations which are engaged in buying and selling goods and services. Exchange rates were introduced in the second half of the 20th-century post the Second World War.

As inter-country trading grew, significant changes were made to then-existing financial mechanisms. 

The Bretton-Woods Conference, the Louvre Accord and the Smithsonian Agreement are famous public meetings of international figures in trade and commerce where such complicated subjects like exchange rates were determined and agreed upon.

Exchange Rate Regimes

Since each country is free to determine its currency exchange policy, there are several different regimes of exchange rates. Countries with open markets like the United States are prone to have an exchange rate that is free and unbound. On the other hand, closeted economies like China have tight control over exchange rates.

Between these polar opposites are hybrid regimes where the exchange rates may be harnessed on occasion by a nation’s Government and Central Bank. India follows a hybrid regime, for example.

Here are the types of exchange rate regimes.

A. Floating Exchange Rates: A floating rate is also known as a fluctuating or flexible exchange regime. It is determined only by prevailing market forces. Any currency which is dependent on a floating regime is also called a floating currency. One good example of a floating exchange currency is the US dollar.

Many economists tend to side with floating exchange rates. They feel that the market should determine a currency’s value and free-market forces should not be manipulated. For example, if the prices of crude oil go up, the prices of USDs tend to fall. There is an inverse relation between these prices.

Since oil prices vary daily, the USD value fluctuates freely.

The markets, economists say, correct themselves frequently. Since there is barely any Government intervention, floating exchanges are popular in most major economies. These are countries which are frequently referred to as ‘First-World Countries.’

DIY Task for you: Now that you know about crude oil and how it plays a significant part in the world economy, find out more about OPEC. Did you know that there is a dispute between Russia and some Middle-Eastern countries over falling oil prices?

In the Indian context, you can track historical data on oil prices and how India’s RBI plays a major role in keeping Foreign Exchange (Forex) levels under control.

Form groups and discuss the ideas of ‘First-World Countries’ and whether this term is outdated.

B. Fixed Exchange Rates: This is sometimes called a pegged exchange rate system because the Governments tend to keep a tight leash on exchange rates. In these regimes, the currency value is fixed, or pegged, against certain foreign currencies- either individually or as a basket- or against its reserves of gold and foreign currencies.

Perhaps the most famous example of a fixed exchange regime is China. The erstwhile USSR also had a fixed rate. In this regime, market forces are not solely relied upon to fix exchange rates. Instead, the country’s Central Banks will sell or buy reserves to set exchange rates when Forex markets are fluctuating widely.

Did you know?

  • Under existing laws, you cannot sell Chinese currency at any rate which differs from pre-decided values. 

  • China’s currency is the Renminbi, also referred to as the “Chinese Yuan.” The People’s Bank of China issues their currency; much like the RBI does in India.

C. Pegged Float Exchange Rate

This system includes 3 different and hybrid regimes. Foreign exchange rates are determined mostly by existing market forces, but Governments and Central Banks can step in to throttle their currency’s exchange rates.

The 3 types are:

Crawling Bands: Here, the Central Bank of a country will permit fluctuations till a specific range, which is usually pre-determined. Once that band is breached, the concerned authorities will step in. Fiscal and economic policies determine these ranges.

Crawling Pegs: Under this system, the Central Bank will allow gradual appreciation or depreciation of its currency on the international market. If there are any market uncertainties, this regime will allow the currency to ‘glide’. However, if appreciation or depreciation follow each other swiftly, the concerned authorities will step in. Argentina, Vietnam and Costa Rica have previously followed this example.

Horizontally Pegged Bands: It is somewhat similar to crawling bands. However, the currency is allowed by Central Banks to fluctuate much more freely – provided the exchange rate does not breach 1% of its currency’s gross value.

Fixed Exchange Rates versus Flexible Exchange Rates

You might be asked to distinguish between fixed exchange rate and flexible exchange rate. Objectively, both these regimes have several pros and cons. There is no consensus on which regime is better. 

  1. Fixed exchange rates encourage capital inflow and foreign trade, besides preventing Forex speculations. However, the fear of devaluation persists. There are always chances of under-and-over-valuation of currencies.

In India, the CBIC exchange rate helps prevent fear-mongering and market speculation.

  1. Flexible exchange rates have advantages including automatic market correction and eliminating any need for foreign exchange reserves. On the down side, currency depreciation may lead to domestic inflation. 

Do you think that India’s managed float exchange rate regime is adequate? Read up on India’s 1991 Balance of Payments crisis on Vedantu and how the New Economic Policy (NEP) has guaranteed India Inc’s success story. Also find all the necessary study materials related to CBSE exchange rate, authored by the experts in this field. 

FAQ (Frequently Asked Questions)

1. What is the Determination of the Exchange Rate?

Ans. An exchange rate determines how much one currency is worth another currency. For example, if you assume that Rs.70 buys 1 USD, then the exchange rate between USD & INR is 1:70.

2.  What is Flexible Exchange Rate?

Ans. If a nation has an exchange rate regime which is governed only by prevailing market forces, it has a flexible or fluctuating exchange rate.

3. Is a Fixed Rate Better than a Flexible Exchange Rate?

Ans. There is no consensus on this affair. Some countries have adopted a flexible rate while some others use a fixed rate. It depends on each country’s socio-political outlook and fiscal policy.