Exchange rates

An exchange rate is the price at which one currency exchanges for another one.

Bi-lateral rates are the specific value of one currency in terms of another – such as 1 US dollar exchanging for 1.10 euros. ‘Average’ rates can be tracked by the use of an index, such as the U.S. dollar index (USDX), or the Sterling Trade-Weighted Index.

These track currency values against a basket of other currencies. Changes are ‘weighted’ to reflect the relative importance of different currencies in terms of trade.

Rate determination

How rates are determined depends upon the system (or 'regime') used.

There are three basic exchange rate regimes:

  1. Fixed rates - where the rate of one currency is pegged to another currency or precious metal
  2. Floating rates - where rates are detemined in the Foreign Exchange market, and vary according to the relative demand and supply of currency
  3. Hybrid systems - which combine elements of fixed and floating systems

Floating rates

In a freely floating system rates are determined by the forces of demand and supply operating in the Foreign Exchange market. The demand and supply of currencies originates from the need to pay for international transactions in local currencies.

When consumers, firms, or governments in one country buy another country’s products or invest in their assets they must exchange their currencies. The demand and supply of currencies ultimately comes from trade and investment flows.

For example, rates are pushed up when demand for a national currency rises as their exports or investment opportunities become more popular abroad. Rates are pushed down when the reverse happens, and they import more from abroad, or invest more in other countries.

Relative interest rates, inflation rates, speculation and confidence levels also affect currency values.

Exchange rate diagram
Video on exchange rates

Fixed rates

In contrast, a fixed system involves currencies being pegged by a country’s central bank, or through a ‘currency board’ – as in the case of the Hong Kong currency board which pegs the Hong Kong dollar to the US dollar. Under the post-war IMF system currencies had a fixed value against the US dollar, which itself was pegged to gold, but this collapsed in 1971, leaving national currencies to float freely, or be pegged, or even abandoned as countries formed single currency zones, such as the Eurozone.

Hybrid systems use a combination of fixed and floating rates.

Examples of exchange rate regimes

Type of exchange rate

Description

Examples

No separate legal
tender

Countries have no legal tender of
their own. Shares currency with
other countries.

Equador
El Salvador
Panama
Zimbabwe

Currency board

This system exists where a country
only issues its own currency at a fixed
rate against another one.

East Caribbean Currency Unit
Bulgaria

Conventional fixed
peg

These systems peg a country’s
currency at a fixed rate to another
currency or basket of currencies.
The exchange rate is allowed to
fluctuate by a small amount,
usually less than 1%.

Barbados
Cameroon
Jordan
Saudi Arabia
Venezuela

Crawling peg and
‘crawl-like’ system

In this system, the currency is
adjusted when required following
changes in economic circumstances
such as inflationary pressures relative
to trading partners.

Argentina
Botswana
China

Managed floating

This is where the rate is allowed to
adjust and where no specific rate
is targeted, but where a particular
objective may be targeted, such as
trying to achieve a balance of
payments with trading partners.

Afganistan
Brazil
Kenya
India

Free floating

This is where a national currency
or a ‘single’ currency is free to find its
own level against other currencies,
and where any intervention is simply
to remove volatility.

Australia
Chile
Euro-zone 19
Japan
UK
USA

Recent exchange rate of Sterling against the US Dollar and Euro

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