The price of one currency in terms of the other currencies is known as the exchange rate. There are generally two types of regimes that determine exchange rates – fixed exchange rate system and flexible exchange rate system.
The differences between the two are as follows:
A Fixed exchange rate is an exchange rate of the currency that is fixed at some level with respect to some benchmarks like US dollar or gold and adjusted only infrequently. Whereas, Flexible/floating exchange rate is an exchange rate which is determined by the forces of demand and supply in the foreign exchange market.
A fixed rate is set by the government or Central Bank and is also maintained at that level. But, in flexible system, the central banks do nothing to directly affect the level of the exchange rate.
Fixed exchange rate regime is less susceptible to volatility and fluctuations and generally depends on change in government policy, whereas currencies under flexible exchange rate regime are susceptible to volatility and high fluctuations as it depends on day to day scenario and market conditions.
Change in exchange rate in fixed regime is termed as devaluation or revaluation whereas in flexible regime it is termed as depreciation or appreciation.
Determination of exchange rate under a flexible exchange rate system:
Let us understand how exchange rate is determined in a flexible exchange rate system, by taking a two country model of say, India and USA:
Under a Flexible Exchange Rate system, the equilibrium rate of exchange is determined by forces of demand and supply of foreign exchange.
The demand of foreign currency arises to import goods & services; to purchase financial assets abroad; send gifts/grants etc. It varies inversely with the exchange rate. This because, at a high exchange rate, the amount of rupees required per unit dollar would be high and vice versa. The demand curve plotted against exchange rate is therefore downward sloping.
Similarly, the supply of foreign currency arises because of export of domestic goods; arrival of foreign tourists; foreigners undertaking direct investment; remittances etc. The supply of foreign currency varies directly with the exchange rate. This is because a higher exchange rate gets more rupees per unit currency. This increases the profitability of the exporters. The supply curve plotted against exchange rate is therefore forward sloping.
The flexible exchange rate system autocorrects any disequilibrium in the balance of payments. This means that any deficit or surplus in the BoP automatically triggers movement in the exchange rate to an equilibrium value where the demand and supply of foreign exchange becomes equal again.
For instance, if a deficit occurs in an economy i.e. increase in imports, there will be excess demand of foreign currency. Such a demand will lead to the appreciation of the foreign currency & depreciation of the domestic currency. Imports will become expensive and exports more profitable. The quantity demanded of the foreign exchange will fall and quantity supplied rise till the deficit is eliminated. This will be the new higher equilibrium value of the exchange rate. Similarly, a surplus in the balance of payments leads to an appreciation of the domestic currency. Hence, exports will fall while imports increase till the surplus is eliminated at the new lower equilibrium value of the exchange rate.