A currency exchange rate represents the rate used by a country to follow its monetary policy. A country’s exchange rate is determined in the foreign exchange marketplace where currency is continually traded. The type of exchange regime followed must be determined by considering the following facts.
1. The Country’s Stage of Economic Development
The type of exchange rate used depends upon a country’s stage of progress economically. For example, a free-floating type of rate of exchange increases volatility, which can hurt developing nations. Most developing economies have their money tied up in other country’s currencies, rather than their local currency. If the local currency depreciates, a bank or business in a developing country will find it challenging to settle any current obligations.
2. The Balance of Trade
When flexible exchange rates are used, it serves to balance the trade in a country, as well as the payments received. If a floating exchange rate is used and a trade deficit occurs, a demand in foreign currency will develop. This increases the price of foreign currencies when compared to the local currency. In turn, foreign products become less attractive in the local marketplace, thereby reducing deficit. If you use a fixed rate of exchange, this type of instantaneous rebalancing does not happen.
3. The Exchange Rate Models Available
Three main types of currency exchange rate models are used for exchanging currency. These models or regimes include a floating exchange rate, a fixed exchange rate, or a pegged float exchange rate. The floating system permits the value of currencies to fluctuate, due to market influences.
On the other hand, a fixed exchange rate represents a system where a currency’s value is tied to the worth of another single currency or to another value measure, such as gold. Pegged float exchange rates represent a system that fixes a rate around a specific value, but permits fluctuations, typically with certain values, to happen.
It is important for countries to differentiate amongst the common exchange rate systems to learn the takeaways and drawbacks for their economy.
4. How the Central Bank Influences the Rates
In some instances, managed float regimes are used to convert currencies. These models of exchange permit fluctuations of exchange rates, but with the influence of a central bank or banks. This influence is supported by the purchase and sales of currencies.
Otherwise called dirty floats, managed float regimes represent rates that fluctuate on a daily basis. Naturally, all currencies are managed, as governments or central banks work toward influencing the worth of currencies. However, when it comes to specific intervention of the government or bank it usually refers to a managed float.
5. The Fiscal Policy of a Country
Another factor introduced in choosing a rate of exchange is a country’s fiscal policy. For instance, if a country chooses to use a fixed rate of exchange, it adjusts its interest rates and alters certain fiscal policies. However, another rate of exchange may be better, as an entity cannot use this type of exchange if it wants to address economic conditions, such as price level, business cycle recessions, or employment.