In economics, an exchange rate is a rate between the countries that are trading partners. This rate decides the exchange of one currency for the other country’s currency. This rate is usually decided in the foreign market exchange. This market is full of buyers and sellers.
Let’s take an example in this regard. There is a rate at which 160 Pakistani Rupees can buy 1 US Dollar. It means 160 Pakistani Rupees has been exchanging for one U.S. Dollar or vice versa. It is important for an investor to know the value of the home currency. Once he has the complete information, only then he should invest in foreign markets. If a U.S. investor is investing in the European market, then he should know the dollar to euro value. If the dollar value is decreasing, then it can increase the foreign investments. But, if the dollar value is increasing, then it can decrease the value of foreign investments.
Type of Exchange Rate System:
Floating and fix exchange rate two types of this system. Let’s discuss them:
Fixed Exchange Rate:
The value of a home currency is usually set fix in a fixed exchange system. In other terms, we can say that home currency value is set to fix against the value of the foreign currency. It is set by either government or the central bank. A country can reap a lot of advantages once it applies to fix exchange rates across the economy. The most common advantage in this regard is it provides stability to home currency.
Floating Exchange Rate:
The forex market decides the value of a home currency in a floating exchange system. The value of a currency depends on the supply and demand of relative currencies. China is one of the world’s leading economies that follow a floating exchange rate.
How Does It Work?
According to an assignment writing service, a currency is bought and sold at different rates in exchange market operations. These rates are set by the money dealers. It is the local currency that helps the dealer to make possible these trades. There are two types of rate; buying and selling. The rate at which the dealer will buy the foreign currency is a buying rate. Furthermore, the rate at which the dealer will sell the currency is the selling rate. There will be a margin between buying and selling rates. This margin will allow the dealer to earn profit. There is always a different rate for a different exchange. For example, cash will exchange in the form of currency notes. Documentary form of exchange will take place in the form of traveller’s checks. So, this way exchange rate market works.
Purchasing Power Parity (P.P.P.):
If you want to determine the value of any product, P.P.P. will help you do that. This value is usually determined in two different ways. First, after adjusting the difference of prices and second, exchange rate. If the value of a book in England is £20 and in the U.S.A. it is $15, then it is not good to compare these different prices. If the exchange rate between these two countries is £2/1$, then you will know that book is expensive in England. It is one of the most important concepts to understand the exchange rate system. Furthermore, it includes two models of the equilibrium exchange rate. Let’s discuss those:
Balance of Payments Model:
This model helps the E.R.M to hold the foreign exchange rates at the equilibrium level. It is only possible if they produce a positive balance. A country is likely to experience reduced foreign reserves if its current trade balance is in deficit. When reserves start getting lower, it decreases the home currency’s value. As a result of this, its exports will become more affordable in foreign markets. At the same time, imports are likely to become more expensive than earlier. After some time, imports will decline, and exports will rise. It will help the country to stabilize the trade balance. As a result of this, it will help the currency to come to an equilibrium level.
Asset Market Model:
Like P.P.P., tangible goods and services are the main focus of this particular model. This model will completely overshadow the role of capital. The transactions amounts are transferred to the capital account. It will go as a balance of payments that will decrease the current account deficit. If there is an increase in the capital flow, then it will give rise to this particular model.
Real versus Nominal Rates:
Real exchange rates is set in a way that presents nominal exchange rates. These rates are set for differences in price levels.
Real Exchange Rate:
It presents the nominal exchange rate along with price ratios of the products in the trading countries.
Nominal Exchange Rate:
It is the rate that helps the domestic currency to receive the foreign currency.
Calculating Exchange Rates:
Suppose we have dollar and pound as two different currencies. According to exchange rate, 2$ can buy 1£. The nominal exchange rate, in this case, is $/£ 2. It means 2$ can buy 1£. In another way, this exchange can be expressed as £/$ 0.5.
Exchange Rate Policy Choices:
It is the key responsibility of the government to consider its economic position. I will also help the country to determine the trade balance. Apart from this, they should make a good policy while selecting an exchange rate regime. A country has a free choice to choose either of these. If a country adopts first regime, it cannot use monetary policies with a free hand. But, the floating exchange rate helps the country to increase foreign reserves.
The exchange rate is set between two countries that are trade partners. This rate decides that how much a currency can be exchanged for another currency. Fixed exchange rate and floating exchange rate are two types of this system. A floating exchange rate helps the country to increase its foreign reserves. In contrast, a fixed change rate restricts the country to excise its monetary policy with a free hand. Apart from this, there is an economic concept of purchasing power parity. It helps the country to maintain foreign reserves and the balance of payments.