Exchange Rate is defined as the rate at which the currency of one country is exchanged with the currency of another country.
- It is the value of one currency in terms of another currency.
- It is a crucial concept in international trade and finance, as it determines how much of one currency is needed to buy a unit of another currency.
Note: If the demand for the currency increases, the exchange rate will rise, and if the supply of currency increases, the exchange rate will fall.
Types of Exchange Rates:
1.) Flexible (Floating) Exchange Rate:
- A flexible exchange rate is one where the value of a currency is determined by the forces of supply and demand in the foreign exchange market, without government or central bank intervention.
- Example: Exchange rate between Nepal and America is flexible.
2.) Fixed Exchange Rate:
- A fixed exchange rate (also known as a pegged exchange rate) is one in which rate of currency is tied or “fixed” to the value of another currency.
- It does not fluctuate with the change in demand and supply of foreign currency.
- Example: Exchange rate between Nepal and India is fixed.
3.) Forward Exchange Rate:
- A forward exchange rate refers to the exchange rate agreed upon today for a currency transaction that will take place at a future date.
4.) Multiple Exchange Rates:
- Multiple exchange rates refer to a situation where a country uses more than one exchange rate for different types of transactions or for different sectors of the economy.
5.) Two-Tier Exchange Rate:
- A two-tier exchange rate system involves having two separate exchange rates: higher rate for commercial transaction and lower rate for capital transactions.
Determinants for Foreign Exchange Rates:
- Foreign demand for exports
- Domestic demand for imports
- Real interest rates
- Price level in the country and other nations
- Profitability of direct investment in domestic business in relation to profitability of similar investment in foreign business.
- Expectations of future changes in the price of domestic currency in terms of foreign currency.
