Exchange Rate

Exchange Rate is defined as the rate at which a country’s currency can be exchanged with another country’s currency. In other words, it is the value of one country’s currency w.r.t. to another country’s currency.
Types of Exchange Rates
Fixed Exchange Rate:
  • In this system, government or central bank ties the country’s currency official exchange rate to another country’s currency (currency peg) or the price of gold (gold standard).
  • Fixed rates provide greater certainty for exporters and importers and also help the government maintain low inflation.
  • The purpose of a fixed exchange rate system is to keep a currency’s value within a narrow band.
Floating/Flexible Exchange Rate:
  • Such exchange rates are also called as market-driven or based exchange rates, which are regulated by factors such as the demand and supply of the domestic and the foreign currencies in the concerned economy.
  • In the floating exchange rate system, a domestic currency is left free to float against a number of foreign currencies in its foreign exchange market and determine its own value.
  • Failure of the gold standard and the Bretton Woods Agreement led to increased popularity of this system.
Managed Exchange Rate:
  • A managed-exchange-rate system is a hybrid or mixture of the fixed and flexible exchange rate systems in which the government of the economy attempts to affect the exchange rate directly by buying or selling foreign currencies or indirectly, through monetary policy (by lowering/raising interest rates on foreign currency bank accounts, etc.)
  • Indian currency, the ‘rupee’, was historically linked with the British Pound Sterling till 1948 which was fixed as far back as 1928.
  • Once the IMF came up, India shifted to the fixed currency system committed to maintaining rupee’s external value (i.e., exchange rate) in terms of gold or the US ($ Dollar).
  • In September 1975, India delinked rupee from the British Pound and the RBI started determining rupee’s exchange rate with respect to the exchange rate movements of the basket of world currencies (£, $, ¥, DM, Fr.). This was an arrangement between the fixed and the floating currency regimes.
  • India announced the Liberalized Exchange Rate Mechanism System (LERMS) in the Union Budget 1992–93 and in March 1993 it was operationalized. India delinked its currency from the fixed currency system and moved into the era of floating exchange rate system under it.
  • Indian form of the exchange rate is known as the ‘dual exchange rate’, one exchange rate of rupee is official and the other is market-driven. The market driven exchange rate shows the actual tendencies of the foreign currency demand and supply in the economy vis-á-vis the domestic currency.
  • It is the market-driven exchange rate which affects the official rate and not the other way round.

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