What is an exchange rate?

An exchange rate is the value of one currency when compared to another. In other
words, it’s how much it costs to buy a sum of foreign money using your local
currency.

There are two main types of exchange rates: floating and fixed. Let’s have a look
at the difference between the two.

It is a rate at which one currency is traded with another. Or in simple words, it is

the value of one currency with respect to another currency. For example, if 1
pound is equal to 2 dollars, this means that you have to pay 2 pounds to purchase
bus ticket of 4 dollars in the USA.

Fixed Exchange Rate System:

Fixed exchange rate is the rate which is officially fixed by the government or
monetary authority and not determined by market forces. Only a very small
deviation from this fixed value is possible. In this system, foreign central banks
stand ready to buy and sell their currencies at a fixed price. A typical kind of this
system was used under Gold Standard System in which each country committed
itself to convert freely its currency into gold at a fixed price.

In other words, value of each currency was defined in terms of gold and, therefore,
exchange rate was fixed according to the gold value of currencies that have to be
exchanged. This was called mint par value of exchange. Later on Fixed Exchange
Rate System prevailed in the world under an agreement reached in July 1994.

(b) Flexible (Floating) Exchange Rate System:

The system of exchange rate in which rate of exchange is determined by forces of

demand and supply of foreign exchange market is called Flexible Exchange Rate
System. Here, value of currency is allowed to fluctuate or adjust freely according
to change in demand and supply of foreign exchange.

There is no official intervention in foreign exchange market. Under this system, the
central bank, without intervention, allows the exchange rate to adjust so as to
equate the supply and demand for foreign currency In India, it is flexible exchange
rate which is being determined. The foreign exchange market is busy at all times
by changes in the exchange rate.

Comparison Chart

BASIS FOR FIXED EXCHANGE FLEXIBLE EXCHANGE

COMPARISON RATE RATE

Meaning Fixed exchange rate refers to Flexible exchange rate is a

a rate which the government rate that variation according
sets and maintains at the to the market forces.
same level.

Determined by Government or central bank Demand and Supply forces

Changes in When currency price When currency price

currency price increases, it is called increases, it is called
revaluation and when price appreciation and when price
decreases, it is called decreases, it is called
devaluation. depreciation.

Speculation Takes place when there is Very common

rumor about change in
government policy.
BASIS FOR FIXED EXCHANGE FLEXIBLE EXCHANGE
COMPARISON RATE RATE

Self-adjusting Operates through variation in Operates to remove external

mechanism supply of money, domestic instability by change in forex
interest rate and price. rate.

What is a Weak Currency

A weak currency refers to the legal tender of a nation that has seen its value
decrease in comparison to other currencies. Weak currencies are often thought to
be those of nations with poor economic fundamentals or systems of governance. In
practice, currencies weaken and strengthen against each other for a variety of
reasons, although economic fundamentals do play a primary role.

Understanding Weak Currency

Fundamentally weak currencies often share some common traits. This can include
a high rate of inflation, chronic current account and budget deficits, and sluggish
economic growth. Nations with weak currencies may also have much higher levels
of imports compared to their exports, resulting in more supply than demand for
such currencies on international foreign exchange markets — if they are freely
traded. While a temporary weak phase in a major currency provides a pricing
advantage to its exporters, this advantage can be wiped out by other systematic
issues.

KEY TAKEAWAYS

 There can be many contributing factors to a weak currency, but a nation's

economic fundamentals are usually the primary one.
 Export dependent nations may actively encourage a weak currency.
 Currency weakness (or strength) can be self correcting in some cases.
Examples of Weak Currencies
Currencies can also be weakened by domestic and international interventions. For
example, China intervened to weaken its currency in 2015 after a long period of
strengthening. Moreover, the imposition of sanctions can have an immediate affect
on a country's currency. As recently as 2018, sanctions weakened the Russian
ruble, but the real hit was in 2014 when oil prices collapsed and the annexation of
Crimea set other nations on edge when dealing with Russia in business and
politics.

Perhaps the most interesting recent example is the fate of the British Pound
as Brexit nears. The UK was a stable currency, but the vote to leave the European
Union set the pound on a very volatile path that has seen it weaken in general as
the process of leaving has plodded along.

Supply and Demand Rule Weak Currencies

Like every asset, currency is ruled by supply and demand. When the demand for
something goes up, so does the price. If most people convert their currencies into
yen, the price of yen goes up, and yen becomes a strong currency. Because more
dollars are needed to buy the same amount of yen, the dollar becomes a weak
currency.

Currency is, after all, a type of commodity. For example, when a person exchanges
dollars for yen, he is selling his dollars and buying yen. Because a currency’s value
often fluctuates, a weak currency means more or fewer items may be bought at any
given time. When an investor needs $100 for purchasing a gold coin one day and
$110 for purchasing the same coin the next day, the dollar is a weakening
currency.

Pros and Cons of a Weak Currency

A weak currency may help a country’s exports gain market share when its goods
are less expensive compared to goods priced in stronger currencies. The increase in
sales may boost economic growth and jobs, while increasing profits for companies
conducting business in foreign markets. For example, when purchasing American-
made items becomes less expensive than buying from other countries, American
exports tend to increase. In contrast, when the value of a dollar strengthens against
other currencies, exporters face greater challenges selling American-made products
overseas.

Currency strength or weakness can be self-correcting. Because more of a weak

currency is needed when buying the same amount of goods priced in a stronger
currency, inflation will climb as nations import goods from countries with stronger
currencies. Eventually the currency discount may spur more exports and improve
the domestic economy provided that there are not systematic issues weakening the
currency.
 In contrast, low economic growth may result in deflation and become a bigger risk
for some countries. When consumers begin expecting regular price declines, they
may postpone spending and businesses may delay investing. A self-perpetuating
cycle of slowing economic activity begins and that will eventually impact the
economic fundamentals supporting the stronger currency.

Potential implications of a lower currency include:

 Export growth. A country's exports can gain market share as its goods get
cheaper relative to goods priced in stronger currencies. The resulting increases in
sales can boost economic growth and jobs, as well as increase corporate profits
for companies that do business in foreign markets.
 Rising inflation. Inflation can climb when economies import goods from
countries with stronger currencies, since it takes more of a weak currency to buy
the same amount of goods priced in a stronger currency. Currently, low economic
growth has resulted in deflation, or falling prices, becoming a bigger risk than
inflation in many countries. A deflationary mindset is undesirable because once
consumers begin to expect regular price declines, they may start to postpone
spending and businesses may begin to delay investment, resulting in a self-
perpetuating cycle of slowing economic activity.
 Relief for debtors. A weak currency can boost inflation, and therefore incomes
and tax receipts, while the value of debt is unchanged, making it easier for local
currency borrowers to pay down debts. Alternatively, a weak currency makes
paying back debt issued to foreign investors and priced in foreign currency more
expensive. Much of the developed world still has high debt burdens, making
inflation somewhat desirable.

Determinants of Exchange Rates

Numerous factors determine exchange rates. Many of these factors 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. Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country
with a lower inflation rate than another's will see an appreciation in the value of its
currency. The prices of goods and services increase at a slower rate where the
inflation is low. A country with a consistently lower inflation rate exhibits a rising
currency value while a country with higher inflation typically sees depreciation in
its currency and is usually accompanied by higher interest rates

2. Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Forex rates,
interest rates, and inflation are all correlated. Increases in interest rates cause a
country's currency to appreciate because higher interest rates provide higher rates
to lenders, thereby attracting more foreign capital, which causes a rise in exchange
rates

3. Country’s Current Account / Balance of Payments

A country’s current account reflects balance of trade and earnings on foreign
investment. It consists of total number of transactions including its exports,
imports, debt, etc. A deficit in current account due to spending more of its currency
on importing products than it is earning through sale of exports causes
depreciation. Balance of payments fluctuates exchange rate of its domestic
currency.

4. Government Debt
Government debt is public debt or national debt owned by the central government.
A country with government debt is less likely to acquire foreign capital, leading to
inflation. Foreign investors will sell their bonds in the open market if the market
predicts government debt within a certain country. As a result, a decrease in the
value of its exchange rate will follow.
5. Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the ratio
of export prices to import prices. A country's terms of trade improves if its exports
prices rise at a greater rate than its imports prices. This results in higher revenue,
which causes a higher demand for the country's currency and an increase in its
currency's value. This results in an appreciation of exchange rate.

6. Political Stability & Performance

A country's political state and economic performance can affect its currency
strength. A country with less risk for political turmoil is more attractive to foreign
investors, as a result, drawing investment away from other countries with more
political and economic stability. Increase in foreign capital, in turn, leads to an
appreciation in the value of its domestic currency. A country with sound financial
and trade policy does not give any room for uncertainty in value of its currency.
But, a country prone to political confusions may see a depreciation in exchange
rates.

7. Recession
When a country experiences a recession, its interest rates are likely to fall,
decreasing its chances to acquire foreign capital. As a result, its currency weakens
in comparison to that of other countries, therefore lowering the exchange rate.

8. Speculation
If a country's currency value is expected to rise, investors will demand more of that
currency in order to make a profit in the near future. As a result, the value of the
currency will rise due to the increase in demand. With this increase in currency
value comes a rise in the exchange rate as well

Functions of foreign Exchange Market

The foreign exchange market is a market in which foreign exchange transactions

take place.
Transfer of Purchasing Power

The Primary function of a foreign exchange market is the transfer of purchasing

power from one country to another and from one currency to another. The
international clearing function performed by foreign exchange markets plays a
very important role in facilitating international trade and capital movement.

Provision of credit

The credit function performed by foreign exchange markets also plays a very
important role in the growth of foreign trade, for international trade depends to a
great extent on credit facilities. Exporters may get pre shipment and post shipment
credit. Credit facilities are available also for importers. The Euro dollar market has
emerged as a major international credit market.

Provision of Hedging Facilities

The other important of the foreign exchange market is to provide hedging facilities.
Hedging refers to covering of foreign trade risks, and it provides a mechanism to
exporters and importers to guard themselves against losses arising from
fluctuations in exchange rates.