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Exchange Rate

Exchange rate is the rate at which one country’s currency can be exchanged for another country’s currency.

How is exchange rate determined?

A fixed exchange rate system refers to the case where the exchange rate is set and maintained at same level by the government irrespective of the market forces.
Floating exchange rate system means that the exchange rate is allowed to fluctuate according to the market forces without the intervention of the Central bank or the government.

Appreciation and Depreciation

The exchange rate for any currency usually fluctuates. When the value of the currency goes up as compared to other currency it is known as appreciation. When the value of currency falls as compared to other currency it is known as depreciation.

Usually the exchange rates are determined by the demand and supply of that currency in the international market.

Demand for any country’s currency on the foreign exchange market is determined by demand for that country’s exports of goods and services and by changes in foreign investment in that country. This is because when foreigners buy another country’s exports of goods or services they must pay for these in the currency of the exporting country.

In the same way Supply of any country’s currency on the foreign exchange market is determined by that country’s imports of goods and services and by its investment in other countries.

Thus when the demand for a currency rises its price goes up and it becomes costlier.

What causes the fluctuation in currency value?

Changes in the imports and exports of the country: An increase in exports of a country will lead to an increase in demand for the currency and thus the value rises.

Changes in Interest rate: Higher interest rate will attract more foreign investors to invest in the country and thus the demand for currency will rise, resulting in appreciation in value of the currency.

Changes in Inflation rate: Higher inflation rate will make the country uncompetitive in the international market. The exports will fall resulting in decreased demand for the currency and hence lower value.

Revaluation and Devaluation

It refers to official changes in the price of a currency in a fixed exchange rate system.

Devaluation is when the price of the currency is officially decreased in a fixed exchange rate system.

Revaluation is the official increase in the price of the currency within a fixed exchange rate system.

 

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