An exchange rate is a rate at which one currency trades for another on the foreign exchange market. Rates of exchange are determined by demand and supply in the foreign exchange market. There are two extreme possibilities in exchange rate Fixed exchange rate. Floating exchange rate.
Fixed Exchange Rate is a rate of exchange between currencies which is set by the governments rather than allowed to change freely with market forces. In order to keep currencies trading at the fixed levels, government economy authorities actively enter the currency market to buy and sell according to variations in supply and demand.
The rate between two currencies that is allowed to fluctuate with the market forces of supply and demand. Floating exchange rates is uncertain as to the future rate at which currencies will exchange, because no one can predict rate in floating exchange rate. The uncertainty is due to increased popularity of forward, futures, and option contracts on foreign currencies. Floating exchange rate is also known as flexible exchange rate.
Let’s have some clear idea of Fixed Exchange Rate by studying following example From the above figure we can say that initially the market of Australian dollar is stable, at 0.96 the supply of dollar is exactly equal to the demand of dollars. There is not need of government intervention to maintain the exchange rate. Assuming the demand of Australian beef is decreasing due to some reason and U.S citizen switch to other country for beef. In this situation Australian product shifts the U.S demand curve for the Australian dollar to the left. U.S demand fewer Australian dollars at ever exchange cost (Cost of an Australian dollar) as it is purchasing less from Australia than it did before. If there were no restriction on trade and assuming the price of Australian dollar were set in such a free market, the shift in the demand curve would lead to a fall in the price of Australian dollar, just the way the price of wheat would fall if there was an excess supply of wheat. U.S and Australian government have committed themselves to maintain the rate at 0.96. To do so either U.S government or Australian government or both must buy up the excess supply of Australian dollars to keep its price from falling. In short, this works when government promises to act as the supplier or demander of last resort. It will ensure that the amount of foreign exchange demanded by the private sector will equal the supply at the fixed price.
The Bank of Latvia has chosen the fixed exchange rate policy for the implementation of monetary policy. Under this strategy, the Bank of Latvia’s intermediate target is the external stability of the national currency,
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