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The exchange rate is the rate at which one currency trades in exchange of another currency. Exchange rate is value which is same as any other value, it is the same price to acquire other things, and in this case it is another currency. It is the price of one currency in terms of another. The exchange rate are differs from one country to another country, it is depends upon various economic factors such as monetary policy, fiscal policy, international policy, general balance, purchasing power of currency, internal as well as external factors and misbalance of market. The rate can be set in different ways; it can be fixed, floating, in terms of some external such as gold. However the best ways to set the value is fixed, as it will be determined by different terms such as price, demand and supply. The high level of demand of currency leads to force up its value means exchange rate. When the supply and demand of currency is equal, it is called as equilibrium exchange rate. Exchange rate is also undertaking long term changes as per relative countries. As the rate of GBP is € 4.50 in 1920.
As € 1.00 = $ 1.55637, if I want to go to America and I would get $ 155 for € 100. Similarly if any individual would come from America, he would get € 100 for $155.
Types of Exchange Rate
There are two different procedures to determine the exchange rate; the first one is that to fix it in exchange of other currency and second one is set it free to float against other currency, it will find it own level. The both types are known as fixed exchange rate and floating exchange rate respectively.
Floating Exchange Rate
The floating exchange rate is the rate which finds its own level of rate as per the forces of demand and supply of currency.
Advantages and Disadvantages of Fixed Exchange Rate
Advantages of Fixed Exchange Rate
Beneficial for Importers and Exporters - As fixed exchange rate provide certainty, it is beneficial for importers and exporters and it is because since certainty is need for international trade and there is a less chances for speculation.
Lower Risk in International trade - When fixed exchange rate is maintain, by agreeing fixed price of products, there is a lower chances for risk in trade. It will also encourage the traders to invest in the markets.
Beneficial for domestic markets and employees - By maintaining fixed exchange rate, domestic organization and employees can maintain their costs under control to cope up in international market; it will lead to inflation in under control. By maintaining this to long run, Interest rates should be down and increase trade and investment opportunities.
Introduces discipline in economic management - Fixed exchange rate gives opportunities to government to from following inflationary policies, and it will lead to be competitive market. This will helps in situation such as balance of payments.
Reduce the risk of destabilizing the economy - The fixed exchange rate is reducing the speculation, it is very risky for business in stable market. And by reducing the speculation will lead to reduce the risk of destabilizing the economy when the exchange rate is fixed.
Beneficial for investment - The vital benefit of fixed exchange rate is that organization can plan the amount of investment and business that organization gets in future. There is no risk of losing more money as it reduces the speculation in exchange.
Disadvantages of Fixed Exchange Rate
No automatic balance of payments adjustment - The floating exchange rate is useful to deal with disequilibrium with interference of national government, and it does not affect the domestic economy also. It there is a situation arise such as deficit then it lead organization to be competitive again, The problem should be solve by reducing the level of aggregating demand, when there is a fixed exchange rate is used. And as demand of products less, will cause less consumption of imports and the price of products falling down and would make organization more completive.
Large amount of foreign reserves require - In order to maintain fixed exchange rate, government have to have large amount of foreign reserves require, and it will lead to opportunity costs to have this reserves.
When the exchange rate is maintain artificially by the government, and it is not up to its level of the economic condition, the development is not up to its level or in other words not efficient as the rate has adjusted. As the interest rate is directly related to exchange rate, it can stop economic growth in case of their disparity to market needs.
Stability of Fixed Exchange rate - The government who adopts fixed exchange rate have follow diverse policies, and it may cause to inflationary sometimes. It creates some problems such as the countries which will have low inflation and it will be very competitive and high inflation and uncompetitive in some countries, have to devalue.
Loss of liberty in internal policy - The needs of fixed exchange rate is dominating policy, sometimes it may not good for the economy at this position. The value of exchange rate should be set by interest rates and other factors; It would be rather than more beneficial to the problems such as unemployment and inflation which is macro objectives.
The main disadvantage of fixed exchange rate is that it will cause problems to economy to speculation attacks. When there is a situation arise such as excess supply and demand in national or other currency, and at that if the government is unable to maintain it, at that time the fixed changed rate needs to be changed, and it will reduces credibility of currency.
Globalization, innovation, technical development plays dominant role in recent world. These processes increase the opportunity of international trade. The economy should be flexible with these progresses, the both fixed exchange rate and floating exchange rate has advantages and disadvantages. Fixed exchange rate is preferable for those countries in which internal factors will creates problems to economy and floating exchange rate is beneficial to those countries in which there are more external shocks.