Types of Foreign Exchange Rates

Throughout history, various international monetary systems and different types of foreign
exchange rate regimes existed. They served to manage not only countries' domestic economic
affairs but also international trade relations. Course material from the University of West Georgia
points out everything from the gold standard and fixed rates to the fiat money and floating
currencies. Foreign exchange rates have become ever more visible in the increasingly global
economic environment and are very useful for both promoting trade and maintaining monetary
stability.

Floating Rates

Floating rates are the main type of foreign exchange rates and the primary reason for currency
fluctuations in foreign exchange markets. All major economies from developed countries allow
the value of their currencies to float freely under market forces. Floating rates are preferable if a
country's economy is strong enough to withstand the constant change in the value of its currency.
For example, a country's currency may lose value in the foreign exchange market if trade deficit
is causing weak demand for the currency and strong demand for foreign currencies. As a lower
currency value is making imports more expensive and exports cheaper, both local and foreign
buyers may switch their demand to the country's domestic goods and services. An economy that
has the resources and means to meet the shifting demand can automatically adjust both foreign
trade and domestic economic activities. Eventually the value of its currency can bounce back up.

Fixed Rates

The smaller economies of developing countries use fixed foreign exchange rates to promote
trade and attract foreign investments. For example, by fixing its currency against the currencies
of other countries, a country keeps export prices affordable to foreign buyers and accumulates
trade surplus over time. Fixed currency rates also allow a country to assure foreign investors of
the stable value of their investments in the country. However, under fixed rates, a country's
monetary policies can become ineffective, especially when trying to stimulate domestic
economic activities by consumers at home. Injecting more money into the economy would
normally reduce a country's currency value against foreign currencies under floating rates. As
imports become more expensive, consumers would gradually focus their demand on domestic

products, potentially lifting up the economy. With fixed rates, however, the exchange value of
domestic currency does not move and more money means more buying power for imports. Such
an outcome does not achieve policy makers' intention to increase domestic demand.

Pegged Rates

Pegged foreign exchange rates are a compromise between floating rates and fixed rates. Under
pegged rates, a country allows its currency to fluctuate within a fixed band around a periodically
adjusted central value. Pegged rates are more appropriate for a transitioning, developing
economy. They allow both stability and a certain degree of market adjustments. While no
artificial exchange rates, fixed or pegged, can fix economic problems single-handed, they do
provide an opportunity for growth. Countries hope that economic improvements can bring in the
foreign currency reserves required to keep the stated rates. When an economy fails to produce
the expected results, such a system cannot maintain the fixed value for long, according to
Brigham Young University in "Fixed Exchange Rates vs. Floating Exchange Rates."

PURCHASING POWER PARITY - PPP'

An economic theory that estimates the amount of adjustment needed on the exchange rate
between countries in order for the exchange to be equivalent to each currency's purchasing
power.

The relative version of PPP is calculated as:

Where:
"S" represents exchange rate of currency 1 to currency 2
"P1" represents the cost of good "x" in currency 1
"P2" represents the cost of good "x" in currency 2

In other words, the exchange rate adjusts so that an identical good in two different countries has
the same price when expressed in the same currency.

For example, a chocolate bar that sells for C$1.50 in a Canadian city should cost US$1.00 in a
U.S. city when the exchange rate between Canada and the U.S. is 1.50 USD/CDN. (Both
chocolate bars cost US$1.00.)
Purchasing Power Parity and Baseball Bats
First suppose that one U.S. Dollar (USD) is currently selling for ten Mexican Pesos (MXN) on
the exchange rate market. In the United States wooden baseball bats sell for $40 while in Mexico
they sell for 150 pesos. Since 1 USD = 10 MXN, then the bat costs $40 USD if we buy it in the
U.S. but only 15 USD if we buy it in Mexico. Clearly there's an advantage to buying the bat in
Mexico, so consumers are much better off going to Mexico to buy their bats. If consumers decide
to do this, we should expect to see three things happen:
1.
American consumers desire Mexico Pesos in order to buy baseball bats in Mexico. So
they go to an exchange rate office and sell their American Dollars and buy Mexican Pesos. As we
saw in "A Beginner's Guide to Exchange Rates" this will cause the Mexican Peso to become
more valuable relative to the U.S. Dollar.
2.
The demand for baseball bats sold in the United States decreases, so the price American
retailers charge goes down.
3.
The demand for baseball bats sold in Mexico increases, so the price Mexican retailers
charge goes up.
4.
Eventually these three factors should cause the exchange rates and the prices in the two
countries to change such that we have purchasing power parity. If the U.S. Dollar declines in
value to 1 USD = 8 MXN, the price of baseball bats in the United States goes down to $30 each
and the price of baseball bats in Mexico goes up to 240 pesos each, we will have purchasing
power parity. This is because a consumer can spend $30 in the United States for a baseball bat, or
he can take his $30, exchange it for 240 pesos (since 1 USD = 8 MXN) and buy a baseball bat in
Mexico and be no better off.
5.

Purchasing Power Parity and the Long Run

6.
Purchasing-power parity theory tells us that price differentials between countries are not
sustainable in the long run as market forces will equalize prices between countries and change
exchange rates in doing so. You might think that my example of consumers crossing the border
to buy baseball bats is unrealistic as the expense of the longer trip would wipe out any savings
you get from buying the bat for a lower price. However it is not unrealistic to imagine an

individual or company buying hundreds or thousands of the bats in Mexico then shipping them
to the United States for sale. It is also not unrealistic to imagine a store like Walmart purchasing
bats from the lower cost manufacturer in Mexico instead of the higher cost manufacturer in
Mexico. In the long run having different prices in the United States and Mexico is not sustainable
because an individual or company will be able to gain an arbitrage profit by buying the good
cheaply in one market and selling it for a higher price in the other market (This is explained in
greater detail in What is Arbitrage? ).
7.
Since the price for any one good should be equal across markets, the price for any
combination or basket of goods should be equalized. That's the theory, but it doesn't always work
in practice.
Anything which limits the free trade of goods will limit the opportunities people have in taking
advantage of these arbitrage opportunities. A few of the larger limits are:
1.
Import and Export Restrictions: Restrictions such as quotas, tariffs and laws will make it
difficult to buy goods in one market and sell them in another. If there is a 300% tax on imported
baseball bats, then in our first example it is no longer profitable to buy the bat in Mexico instead
of the United States. The U.S. could also just pass a law make it illegal to import baseball bats

1.
Travel Costs: If it is very expensive to transport goods from one market to another, we
would expect to see a difference in prices in the two markets. This even happens in places that
use the same currency; for instance the price of goods is cheaper in Canadian cities such as
Toronto and Edmonton than it is in more remote parts of Canada such as Nunavut.
2.
Perishable Goods: It may be simply physically impossible to transfer goods from one
market to another. There may be a place which sells cheap sandwiches in New York City, but that
doesn't help me if I am living in San Francisco. Of course, this effect is mitigated by the fact that
many of the ingredients used in making the sandwiches are transportable, so we would expect
that sandwich makers in New York and San Francisco should have similar material costs. This is
the basis behind the Economist's famous Big Mac Index. Their article McCurrencies is a must
read.
3.
Location: You cannot buy a piece of property in Des Moines and move it to Boston.
Because of that real-estate prices in markets can vary wildly. Since the price of land is not the
same everywhere, we would expect this to have an impact on prices, as retailers in Boston have
higher expenses than retailers in Des Moines.
So while purchasing power parity theory helps us understand exchange rate differentials,
exchange rates do not always converge in the long run the way PPP theory predicts.
Mint Parity Theory of Rate of Exchange

When the currencies of two countries are on metallic standard (gold or silver standard), rate of
exchange between them is determined on the basis of parity of minorities between currencies of
the two countries. Thus, the theory explaining the determination of exchange between countries
which are on the same metallic standard (say gold coin standard), is known the Mint Parity
Theory of foreign exchange rate.
By mint parity is meant that the exchange rate is determined on a weight-to-weight basis of two
currencies, allowances being made for the parity of the metallic content of the two currencies.'
Thus, the value of each coin (gold or silver) will depend upon the amount of metal (geld or
silver) contained in the coin; and it will freely circulate between the countries. For instance,
before World War I, England and America were simultaneously on a full-fledged gold standard.
While gold sovereign (Pound) contained 113.0016 grains of gold, the gold dollar contained
23.2200 grains of gold standard purity. Since the mint parity is the reciprocity of the gold content
ratio between the two currencies, the exchange rate between the American dollar and the British
Sovereign (Pound) based on mint parity, was 113.0016/23.2200, i.e., 4.8665. That means, the
exchange rate: 1 = 4.8665, can be defined as the mint parity exchange between the pound and the
dollar.
Thus, under gold standard conditions the exchange rate tended to stay close to the ratio of gold
values of the currencies or mint parity. The exchange rate was, however, free to fluctuate within
limits called the gold points or series. Since gold could be freely bought and sold between
countries, these gold points were determined by the costs of insurance, transportation and
handling charges incurred in the shipment of gold. At the gold points the supply and demand
schedule becomes perfectly elastic.
OE is the equilibrium rate of exchange as per the mint parity (under gold standard system) at
which the demand for and supply of foreign exchange (dollar from Britain's point of view) are
equal. Further, it can be seen that a change in the supply schedule for dollars within the interval
ZT (or ad) would simply result in a divergence of the exchange rate from mint parity; a shift in
the demand for dollars within the range RQ (or bs) would similarly result in a deviation of the
rate from mint parity.
Thus, exchange rate may rise upto OU or fall upto OL. But it cannot rise beyond the gold export
point or fall below the gold import point, because at these points the demand for and supply of
foreign exchange (pound in our illustration) becomes perfectly elastic by the outflow or inflow of
gold. Therefore, the supply curve becomes SS' and the demand curve dd' in the diagram.
The point s/a is regarded as "gold export point"; at this point the demand curve becomes
perfectly elastic. Similarly, the point d/b is regarded as "gold import point"; at this point the
supply curve becomes perfectly elastic. U and L thus, set the limit to a deviation of equilibrium
exchange rate from mint parity. And the equilibrium will be restored conceptually in this
situation when the country

gaining gold finds its money supply increasing and prices and incomes rising, while the reverse
will happen in the case of a gold exporting country.
The specie (gold) points are important in the determination of foreign exchange rate under
g( standard because they give us an idea of the maximum fluctuations to which the exchange rate
the foreign exchange market is subject from day-to-day. They also explain why and how the
actual rate of exchange differs from that normal rate of exchange which is determined by the
mint parity criterion.
Today, however, the method of determining currency values in terms of gold content or m parity
is obsolete for the obvious reasons that:
(i) none of the modern countries in the world is gold or metallic standard,
(ii) free buying and selling of gold internationally is not permitted various governments. As such
it is not possible to fix par values in terms of gold content or mint parity, and
(iii) most of the countries today are on paper standard or Fiat currency system.

Factors That Influence Exchange Rates

Aside from factors such as interest rates and inflation, the exchange rate is one of the most
important determinants of a country's relative level of economic health. Exchange rates play a
vital role in a country's level of trade, which is critical to most every free market economy in the
world. For this reason, exchange rates are among the most watched, analyzed and
governmentally manipulated economic measures. But exchange rates matter on a smaller scale as
well: they impact the real return of an investor's portfolio. Here we look at some of the major
forces behind exchange rate movements.
Overview
Before we look at these forces, we should sketch out how exchange rate movements affect a
nation's trading relationships with other nations. A higher currency makes a country's exports
more expensive and imports cheaper in foreign markets; a lower currency makes a country's
exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can
be expected to lower the country's balance of trade, while a lower exchange rate would increase
it.
Determinants of Exchange Rates

Numerous factors determine exchange rates, and all are related to the trading relationship
between two countries. Remember, exchange rates are relative, and are expressed as a
comparison of the currencies of two countries. The following are some of the principal
determinants of the exchange rate between two countries. Note that these factors are in no
particular order; like many aspects of economics, the relative importance of these factors is
subject to much debate.
1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last half of the
twentieth century, the countries with low inflation included Japan, Germany and Switzerland,
while the U.S. and Canada achieved low inflation only later. Those countries with higher
inflation typically see depreciation in their currency in relation to the currencies of their trading
partners. This is also usually accompanied by higher interest rates. (To learn more, see Cost-Push
Inflation Versus Demand-Pull Inflation.)
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest
rates, central banks exert influence over both inflation and exchange rates, and changing interest
rates impact inflation and currency values. Higher interest rates offer lenders in an economy a
higher return relative to other countries. Therefore, higher interest rates attract foreign capital and
cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if
inflation in the country is much higher than in others, or if additional factors serve to drive the
currency down. The opposite relationship exists for decreasing interest rates - that is, lower
interest rates tend to decrease exchange rates.
3. Current-Account Deficits
The current account is the balance of trade between a country and its trading partners, reflecting
all payments between countries for goods, services, interest and dividends. A deficit in the
current account shows the country is spending more on foreign trade than it is earning, and that it
is borrowing capital from foreign sources to make up the deficit. In other words, the country
requires more foreign currency than it receives through sales of exports, and it supplies more of
its own currency than foreigners demand for its products. The excess demand for foreign
currency lowers the country's exchange rate until domestic goods and services are cheap enough
for foreigners, and foreign assets are too expensive to generate sales for domestic interests.
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations with large

public deficits and debts are less attractive to foreign investors. The reason? A large debt
encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off
with cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large debt, but
increasing the money supply inevitably causes inflation. Moreover, if a government is not able to
service its deficit through domestic means (selling domestic bonds, increasing the money
supply), then it must increase the supply of securities for sale to foreigners, thereby lowering
their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country
risksdefaulting on its obligations. Foreigners will be less willing to own securities denominated
in that currency if the risk of default is great. For this reason, the country's debt rating (as
determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its
exchange rate.

5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts
and the balance of payments. If the price of a country's exports rises by a greater rate than that of
its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater
demand for the country's exports. This, in turn, results in rising revenues from exports, which
provides increased demand for the country's currency (and an increase in the currency's value). If
the price of exports rises by a smaller rate than that of its imports, the currency's value will
decrease in relation to its trading partners.

6. Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic performance in
which to invest their capital. A country with such positive attributes will draw investment funds
away from other countries perceived to have more political and economic risk. Political turmoil,
for example, can cause a loss of confidence in a currency and a movement of capital to the
currencies of more stable countries.

Conclusion
The exchange rate of the currency in which a portfolio holds the bulk of its investments
determines that portfolio's real return. A declining exchange rate obviously decreases the
purchasing power of income and capital gains derived from any returns. Moreover, the exchange
rate influences other income factors such as interest rates, inflation and even capital gains from

domestic securities. While exchange rates are determined by numerous complex factors that
often leave even the most experienced economists flummoxed, investors should still have some
understanding of how currency values and exchange rates play an important role in the rate of
return on their investments.