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.
How rates are determined depends upon the system (or 'regime') used.
There are three basic exchange rate regimes:
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.
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.
Type of exchange rate |
Description |
Examples |
No separate legal |
Countries have no legal tender of |
Equador |
Currency board |
This system exists where a country |
East Caribbean Currency Unit |
Conventional fixed |
These systems peg a country’s |
Barbados |
Crawling peg and |
In this system, the currency is |
Argentina |
Managed floating |
This is where the rate is allowed to |
Afganistan |
Free floating |
This is where a national currency |
Australia |