How Currency Exchange Rates work?

You might have traveled to U.S or Europe and exchanged Indian Rupees for American Dollars or Euro. We need to exchange currencies because our nation's currency is not always accepted in another country. You can't shop in U.S. with Indian Rupees, you need to buy dollars with rupees from any bank to spend money in U.S.

We often come across in news, 'The rupee fell against the dollar' or 'The dollar fell against the euro'. This might confuse some people who are not from finance background.

The exchange rate expresses the national currency's price in respect to foreign ones. For example, if one US dollar is worth 45 Indian rupees, then the exchange rate of a dollar is Rs 45, thus Rs 180 is $4.

How exchange rates are valued?
The exchange rates are valued on various factors. One of the important factors is demand and supply. Higher the demand, more the price of particular currency and vice-a-verse. The change in rate also takes place due to market upheavals or any major event that takes place in the world.

Thus, when the news flows in the market, 'The rupee fell against the dollar', this indicates - the price of rupee depreciated in terms of dollar, this happens due to the higher demand of dollar as compared to rupee.

Methods of Exchange:
There are two different ways to determine Exchange Rate: Floating Exchange Rate System and Pegged Exchange Rate System.

Floating Exchange Rate System:
Floating Exchange Rate system is driven by market forces i.e. through supply and demand. It's the system where currency can freely move in any direction. It is also known as 'freely floating exchange rate' or 'flexible exchange rate'.

In such system, currency is worth what buyers are willing to pay for it. Supply and demand factors are driven by amount of foreign investment (Foreign Direct Investment and Foreign Institutional Investment) in country, import-to-export ratios, inflation and many other economic factors.

Countries with stable economy use floating rate regime. This system of exchange rate determination has been used by major countries in the world like U.S., Britain, India, Japan, etc.

Floating Exchange rate system is more efficient because it reflects transparency and it factors all major economic indicators like inflation, GDP figures, etc.

However, Floating Exchange rate system may not work efficiently during economic instability.

Pegged Exchange Rate System:
Pegged Exchange Rate system also known as 'Fixed Exchange Rate system', is the system where exchange rate is set and artificially maintained by the government. The government usually peg their country's currency to some other country's currency, usually U.S. Dollar and the rate does not fluctuate from day to day in such case.

Usually, a country peg to a certain dollar range. So, when the dollar falls below that range, the country will buy dollars or buy U.S. Financial instruments let say, U.S. Treasuries, to increase the value of dollar again and vice-a-verse.

China is one of the example who has pegged its currency to U.S. Dollar to maintain competitive pricing.

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