What is Determination of the exchange rate?
Different nations have distinct methodologies of deciding their currency’s exchange rate. It can be decided via Fixed Exchange Rate or Managed Floating Exchange Rate, Flexible Exchange Rate.
Flexible Exchange Rate
This exchange rate is decided by the market place forces of demand and supply. It is also called as Floating Exchange Rate. As represented in the below given figure, the exchange rate is decided where the demand curve converges with the supply curve, that is, at point e on the Y – axis. Point q on the x – axis decides the quantity of US $ that have been demanded and supplied on e exchange rate. In a fully flexible system, the Central banks do not interfere in the foreign exchange market place.
Money in any nation is an asset. If Indians credit that British pound would go high in value compared to the rupee, they would want to hold pounds. Hence, exchange rates also get impacted when people hold foreign exchange on the anticipation that they can accrue profits from the appreciation of the currency.
Exchange Rate and Interest Rates
Another aspect that is significant in deciding exchange rate is the interest rate distinctive that is the difference between interest rates between nations. There are immense amount funds owned by banks, MNCs and affluent individuals which move around the globe in search of the highest percentage interest rates.
Exchange Rates in the Long Run
The theory of PPP or purchasing Power parity is utilised to make long-run anticipations regarding exchange rates in a flexible exchange rate structure. Conforming to the theory, if there are no frontiers to business like taxes (tariffs on business) and quotas (quantitative constraints on imports), exchange rates must gradually adapt so that the same product cost prices the same whether quantified in rupees in India or yen in Japan, dollars in the US, except for dissimilarities in terms of transportation.
The above mentioned is the concept that is explained in detail about Determination of the Exchange Rate for the class 12 students. To know more, stay tuned to BYJU’S.