An exchange rate is the amount of one currency that is needed to buy one unit of another currency.
For example, the GBP/USD exchange rate is 1.20.
This means that it takes 1.20 U.S. dollars to buy 1 British pound.
For example, if a company needs to purchase inventory from abroad, they often have to exchange their own currency for that of the supplier in order to make payment.
The exchange rate comes directly into play to decide the quantity of the home currency that is necessary to meet the price of the supplier currency. Exchange rates are inherently volatile and prone to risk.
Types of Exchange Rates
There are two types of exchange rates:
What are fixed exchange rates?
A fixed exchange rate is where a currency of one country is “pegged” to a stronger currency.
The purpose is to maintain the weaker currency’s value within a tight range, in order to protect the currency from wild fluctuations.
Fixed exchange rates protect the valuation of a weaker currency by providing less uncertainty regarding importing and exporting prices.
This helps the central bank maintain low-interest rates and thus, low inflation rates.
The aim is to stimulate trade and the overall economy.
Countries traditionally peg their currency to the currency of their largest trading partner.
For example, many African nations have pegged their currencies to the euro. And many Latin American countries have pegged their currencies to the U.S. dollar.
What are floating exchange rates?
In contrast to fixed exchange rates, floating exchange rates are currency pairings whose price constantly changes.
Free-floating currencies are the most widely used in global commerce.
They are used almost everywhere in the “developed” world.
Floating exchange rates can change by the second, as a result of the constantly changing variable factors that influence a currency’s strength.
The strength of a currency is measured in its comparison to other currencies through exchange rates.
They fluctuate as currency value is determined by a series of supply and demand factors, including trade flows, tourism, interest rates, rates of inflation, political stability, and speculation.
For example, if interest rates are increased substantially, in Japan, demand for Japanese yen will increase as people will invest money in the Japanese currency to take advantage of the interest rate increase and make money. If interest rates fall, the opposite consequence is highly likely to occur.
Therefore, governments attempt to control various factors to ensure exchange rates are at a level that will help their respective economies grow. A delicate balance often has to be struck.