Foreign exchange rate refers to the rate at which one unit of currency of a country can be exchanged for the number of units of currency of another country. In other words, it is the price paid in domestic currency in order to get one unit of foreign currency.
Example: $1= ₹50 or 1/50 Dollar = 2 cents
Thus, exchange rate expresses the ratio of exchange between the currencies of two countries. It is the price of a currency expressed in terms of another currency, Some economists refer to it as the external value of the currency.
The rate of exchange measures number of units of one currency which is exchange in the foreign market for one unit of another
System of Exchange Rate
Broadly, Foreign Exchange Rate consists two systems (or types) evolved over time:
(1) Fixed Exchange Rate System, and
(2) Flexible Exchange Rate System
Fixed Exchange Rate System
Fixed-rate of exchange is a floating rate of exchange, determined by the supply of and demand for different currencies. it has two important variants:
(a) Gold Standard System of Exchange Rate
(b) Bretton Woods System of Exchange Rate
Gold Standard System Fixed Exchange Rate
According to this system (prevalent in most countries prior to 1920s), gold was taken as the common unit of parity between currencies of different countries in circulation.
Bretton Woods System of Exchange Rate
Bretton Woods System, even when it was a fixed system of exchange rate, allowed some adjustments. So, it was called ‘adjustable peg system of exchange rate.
According to this system,
- Different currencies were pegged to one currency, that is US dollar.
- US dollar was assigned gold value at a fixed price.
- Value of one currency in terms of US dollar ultimately implied value of that currency in term of gold .
- Gold continued to be the ultimate unit of parity between any two currencies.
- Adjustment in the parity value of a currency was possible but only if allowed by IMF (International Monetary Fund).
Flexible Exchange Rate System
Scarcity of gold and its unequal availability across different nations on one hand amd increasing demand for gold (as a reserve liquid asset) on the other, led to the decay of fixed exchange rate system. It was replaced by a flexible exchange rate system in 1977.
Flexible rate of exchange is that rate which is determined by the supply-demand forces in the foreign exchange market.it is also called ‘free exchange rate’ as it is determined by the free play of supply and demand forces in the international money market.
The exchange rate at which demand for foreign currency is equal to its supply is called Par Rate of Exchange or Equilibrium Rate of Exchange.
Determination of Flexible Exchange Rate
The theory of determination of flexible rate of exchange is the demand and supply theory. According to this theory, the rate of exchange of a country’s currency determined by its demand and supply in the international money market. While there is an inverse relationship between price and demand, price and supply are positively related.
So that, while the demand curve tends to slope downward, supply curve tends to slope upward. In the words of Kurihara.
A free exchange rate tends to be such as to equate the demand for and supply of foreign exchange.
Spot exchange rate (also known as current rate of exchange) is that rate of exchange which happens to prevail in the market at the time when transactions are incurred. It relates only to spot transactions in the international money market.
Forword exchange rate is that exchange rate at which forward transactions are to be honoured. it has nothing to do with spot transactions in the international money market. In fact, forward exchange rate isa sort of ‘contracted’ exchange rate to be applicable for the transactions which are signed today but are to be honoured sometimes in the future.