Exchange Rates UPSC: In economy and finance, the exchange rate is the rate at which one currency will be exchanged for another currency. here currency means any country’s national currency or sub-national currency, it affects trade and the movement of money between countries.
in other words, The exchange rate is the value of one country’s currency in relation to another currency.
Example: In October 2022, the exchange rate from 1 INR (Indian Rupees) to the U.S. Dollars was 0.012, meaning it takes to 1INR to buy 0.012 $.
Types of exchange rate
Mainly there are two types of exchange rates worldwide, a country’s monetary authority determines the exchange rate regime that will apply to its current. the two types of exchange rates are:
- Floating exchange rate
- Fixed exchange rate or pegged exchange rate
Floating exchange rate: in finance floating exchange rate is the exchange rate that is determined solely by market forces and often manipulated by open-market operations. Countries do have the ability to influence their floating currency from activities such as buying/selling currency reserves, changing interest rates, and through foreign trade agreements, etc.
Fixed exchange rate or pegged exchange rate: in the fixed exchange rate on the other hand value of any country’s home currency is directly proportional to the value of another currency or commodity. there are many currencies that were fixed (or pegged) to gold for many years. This means, If the value of gold rose, the value of the currency fixed to gold would also rise. Today, many countries currencies are fixed (pegged) to floating currencies from major other nations’ currencies. Many countries fixed their currency value to the U.S. Dollar, the Euro, or the British Pound.
example: The Hong Kong dollar is pegged to the U.S. dollar in a range of 7.75 to 7.85.3 This means the value of the Hong Kong dollar to the U.S. dollar will remain within this range.
Countries are free to choose which type of exchange rate regime they will apply to their currency. The main types of exchange rate regimes are: free-floating, pegged (fixed),
Forex market
The forex market also said to be a foreign exchange market, allows banks, financial institutions, funds, and individuals to buy, sell or exchange currencies. The market operates 24 hours, 5.5 days a week.
Exchange rate: classification
From the perspective of bank foreign exchange trading:
Buying rate: it is also known as the purchased price, it is the price paid by the foreign exchange bank to buy foreign currency from the customer.
In general, the buying rate is the exchange rate where the foreign currency is converted to a smaller number of domestic currencies, which shows how much the country’s currency is required to buy a certain amount of foreign currency.
Selling rate: it is Also known as the foreign exchange selling price, it refers to the exchange rate used by the bank to sell foreign exchange to customers. It indicates how much the country’s currency needs to be taken if the bank sells a certain amount of foreign exchange.
Middle rate: it is The average of the bid price and the asking price and it is Commonly used in newspapers, magazines or economic and financial analysis.
According to the length of delivery after foreign exchange transactions
Spot exchange rate: it is the exchange rate of spot foreign exchange transactions. That is, after the foreign exchange transaction is completed, the exchange rate is in Delivery is within two working days.
in other words, The spot exchange rate is best thought of as how much you would have to pay in one currency to buy another at any moment in time. Spot rates are usually set through the global foreign exchange market (forex) where currency traders, institutions, and countries clear transactions and trades.
Forward exchange rate: The forward exchange rate is the rate of exchange, agreed upon now, for a foreign exchange market transaction that will occur at a specified date in the future. The agreement to make such an exchange in the future at a rate agreed upon now is called a forward contract.
Cross rate: After the basic exchange rate is worked out, the exchange rate of the local currency against other foreign currencies can be calculated through the basic exchange rate. it is called the cross-exchange rate.
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According to the payment method in foreign exchange transactions
Telegraphic exchange rate: A telegraphic transfer is an electronic method of transferring funds, primarily for foreign wire transactions.
Mail transfer rate: An email money transfer allows users to transfer funds between personal accounts, using email and their online banking service. the related exchange rate is called the mail transfer rate.
Demand draft rate
According to the level of foreign exchange controls
Official rate: it is Usually used by countries with strict foreign exchange controls. it is the rate of exchange announced by a country’s foreign exchange administration.
Market rate: market exchange rate refers to the real exchange rate for foreign exchange trading in the free market. It fluctuates according to the foreign exchange supply and demand conditions.
According to the international exchange rate regime
Floating exchange rate: It means that the monetary authorities of a country do not stipulate the official exchange rate of the country’s currency against other currencies, nor does it have any upper or lower limit of exchange rate fluctuations. The local currency is determined by the supply and demand relationship of the foreign exchange market, and it is free to rise and fall.
Fixed exchange rate: It means that the exchange rate between a country’s currency and another country’s currency is basically fixed, and the fluctuation of the exchange rate is very small.
Whether inflation is included
Nominal exchange rate: an exchange rate that is officially announced or marketed which does not consider inflation.
In other words, The nominal exchange rate (NER) is the relative price of the currencies of two countries. For example, if the exchange rate is 1 Rupee = 0.012 $, then an Indian can exchange 1 rupee for 0.012 dollars in the world market. Similarly, an American can exchange 0.012 dollars to get one Rupee.
Real exchange rate: it refers to the relative price of goods of India and the USA. The Real Exchange rate is the rate at which the Indians can trade their own goods for those of the USA. The real rate is another name for the terms of trade, which is expressed as Px/Pm, where Px is the price of export and Pm is the price of the import.
Real Exchange rate Formula: it is expressed as:
This means that the rate at which the Indians can exchange foreign and domestic goods depends on two factors:
(i) The rate at which the two currencies are exchanged; and
(ii) The price of the good in local currency.
A high (low) Real Exchange Rate implies that foreign goods are relatively cheap (expensive) and domestic goods are relatively expensive (cheap).