Determination of the Exchange Rate

Determination of the Exchange Rate – Meaning

Every nation has a distinct methodology to decide its currency’s exchange rate..  It can be decided via three methods which are : fixed exchange rate, managed floating exchange rate or pegged exchange rate, and flexible exchange rate.

Flexible Exchange Rate

This exchange rate is decided by the marketplace forces of demand and supply. It is also known as the floating exchange rate. As represented in the given figure, the exchange rate is decided where the demand curve converges with the supply curve, that is, at point e on the y-axis. Point q on the x-axis decides the quantity of US $ that has been demanded and supplied on   exchange rate. In a fully flexible system, the Central banks do not interfere in the foreign exchange marketplace.

Speculation

Money, in any nation, is an asset. If Indians credit that the British pound would go high in value compared to that of the rupee, then they would want to hold pounds. Hence, the exchange rates also get impacted when people hold foreign exchange in the anticipation that they can accrue profits from the appreciation of the currency.

Exchange Rate and Interest Rates

Another aspect that is significant in deciding the exchange rate is the distinctive interest rates, that is, the difference between the interest rates between the nations. There are immense amounts of funds owned by banks, MNCs, and affluent individuals that move around the globe in search of the highest percentage interest rates.

Exchange Rates in the Long Run

The theory of PPP or purchasing power parity is utilised to make long-run anticipations regarding the exchange rates in a flexible exchange rate structure. Conforming to the theory, if there are no frontiers to the business like taxes (tariffs on business) and quotas (quantitative constraints on imports), then the exchange rates must gradually adapt so that the same products cost the same prices whether quantified in rupees in India, yen in Japan, or dollars in the US, except for the dissimilarities in terms of transportation.

The above-mentioned is the concept that is explained in detail about the Determination of the Exchange Rate for the class 12 students. To know more, stay tuned to our website.