How exchange rate is determined??? August 7, 2007Posted by nsworld in Business and Economy.
This is the one question that crops up in everyone’s mind, whenever we read reports such as, Rs. appreciating, US Dollar falling down, everywhere.
In a very simple language ,we can say that Demand and supply determines the value of any currency against any other currency. Suppose the demand for Rupee is higher owing to excess supply of dollar (i.e. more number of people want to convert their dollar in to Rupee), value of dollar will naturally decline against Rupee. This is the fundamental principle of Demand and Supply driven Exchange rate.
Not every nation on the earth follows the system of Demand and supply for determining the exchange rate. Some have pegged the value of their currency against others (like china) and some follow the route of `Free float` and intervention (by central bank) now and then whenever required (like India).
`Gold Standard`It was the earliest method used for determining the value of a currency… Under the gold standard, currency issuers guarantee to redeem notes, upon demand, in that amount of gold. Governments that employ such a fixed unit of account, and which will redeem their notes to other governments in gold, share a fixed-currency relationship.This system avoids frivolous printing of currency and keeps the inflation under check. With expanding trade beyond geographies and transactions taking place across nations, this system of Gold standard was ill equipped to address the concerns and complexities of the new changing and dynamic world order.
Bretton Woods SystemThis new order came in to exisistence in 1944. Preparing to rebuild the international economic system as World War II was still raging, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, for the United Nations Monetary and Financial Conference. The delegates deliberated upon and signed the Bretton Woods Agreements during the first three weeks of July 1944.Here the participating countries agreed to fix the value of their currencies with in the fixed value (i.e. plus or minus some percentage in terms of gold) and it was also agreed that IMF would help those nations in case of serious problems in Balance of Payments.But this system also collapsed in 70s when US unilaterally decided to move out of this system and refused to convert the dollar into gold.
Demand and Supply This is the simple and most effective method to determine the value of currency which is used almost everywhere worldwide. (With some exceptions and modifications)This is also popularly called as free float system, where the market forces are given a free hand to determine the value of any currency based on Demand and supply for respective currencies. Today in India we follow a middle path that is in-between free hand to market forces and occasional intervention by central banker. Still we have very long way to go so that our exchange rate is completely determined by market forces. , For that various other regulatory issues including `Capital account convertibility `have to be sorted out. Then what are the advantages or disadvantages of opting for `no intervention policy by government` is another topic for debate and we will discuss some time later…