Exchange Rate Mechanisms

Topics: Monetary policy, Inflation, Foreign exchange market Pages: 3 (1388 words) Published: October 26, 2014

Exchange Rate
The rate at which the currency unit of one country may be exchanged for that of another. Exchange rate plays a critical role in country’s level of trade. An exchange rate has two components, the domestic currency and a foreign currency, and can be quoted either directly or indirectly. In direct quotation, the price of a unit of foreign currency is expressed in terms of the domestic currency. Eg: 1 US Dollar = 60.21 INRIn an indirect quotation, the price of a unit of domestic currency is expressed in terms of the foreign currency.Eg: 1 INR = 0.017 USD Types of exchange rate

Fixed exchange rate: In fixed exchange rate system, the central bank intervenes in currency market in order to keep currency closed to fixed target.  It is committed to a single fixed exchange rate and does not allow major fluctuations from this central rate. Free floating exchange rate: The value of the currency is determined solely by supply and demand in the foreign exchange market. Consequently, trade flows and capital flows are the main factors affecting the exchange rate. Pure free floating exchange rates are rare - most governments at one time or another seek to manage the value of their currency through changes in interest rates and other means of controls. Pegged exchange rate: A pegged exchange rate system is a hybrid of fixed and floating exchange rate regimes. Typically, with a pegged exchange rate, an initial target exchange rate is set and the actual exchange rate will be allowed to fluctuate in a range around that initial target rate. Also, given changes in economic fundamentals, the target exchange rate may be modified. How is exchange rate influenced by demand and supply?

Exchange rate can be volatile as demand and supply depends on various factors. Demand: If demand for a currency increases keeping supply constant, the currency appreciates.Supply: Currency depreciates if supply of currency is increased keeping demand constant.Eg : The purchase of Indian...
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