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Foreign Exchange Rate System Simplified

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If you are a frequent traveler you must have know that what is foreign exchange rate or how the system of foreign exchange rate works in this article we are going to discuss meaning of foreign exchange rate system of exchange rate.

Foreign Exchange Rate in Simple words

The term foreign exchange rate refers to the rate at which one currency of a country which can be exchanged for the number of currency of another country, in simple language it is the price paid in one currency to get the other foreign currency. According to

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System of exchange rate

If we classify the foreign exchange rate system we get two exchange rate system
First one is fixed exchange rate system and second one is flexible exchange rate system.

Fixed exchange rate system

In the fixed exchange rate system the price of currency is fixed by the government, and it is not frequently change, for example gold standard system of exchange rate system.

Gold standard system of exchange rate

In this gold standard system of exchange rate countries define the value of their currencies in terms of gold and the value of gold it is fixed so if someone wants to exchange their currency the value of their currency is valued in terms of gold to exchange from one to another.

For example if UK pound is equal to 24 g of gold and US dollar is equal to 2 gram of gold then 1 UK pound is equal to US dollars
In this case, the exchange rate between UK and US is 1 is to 2 to US dollars would exchange for one UK pound.

Adjustable peg system of exchange rate

In Adjustable peg system, different currency value is valued with the value of 1 currency that is us dollar
US dollar was assigned through its gold value at a fixed price.
Value of one currency in terms of dollar automatically applied to the value of currency in terms of gold
Gold continued to be the ultimate unit of comparison between the two system.
Adjustment in the parity value of currency was possible, but only if allowed by the International Monetary Fund.

Flexible exchange rate system

With the increase in the demand of gold and from 1977 it was replaced by flexible exchange rate system
Flexible exchange rate system is the system where the value of currency is determined by the demand and supply of currency in the foreign exchange market.
It is actually called free exchange rate as it is determined by the free forces of market which is demand and supply in the international monetary market.

Sources of foreign exchange in 2022

One country can get foreign currency in many ways, some of them are listed below.

Exports-exports of goods and services is the important source of supply of foreign exchange reserves from one country to another country, so it also determines the foreign exchange rate system.

Imports-as, like exports, imports are also a good source of foreign exchange from another country.

Foreign direct investment-Investments from the rest of the world include FDI in a country is a good source of supply of foreign exchange.

Direct purchase by rest of the world-Many countries purchase currency of other country as you put them on hold or as a commodity of exchange.

Loans from rest of the world– One country can get foreign exchange in form of loans from other countries to build infrastructure in their countries, and it will give boost to their economies as well.

Grants and donation received by the country from rest of the world– is also considered as the foreign exchange demand and supply of a country with rest of the world.

Income received– foreign exchange also flows from rest of the world to the domestic country by the way of income earned by its national.

Remittance sent by non-residential-People who work in foreign countries send foreign exchange to their family and friends, it also contributes to the foreign exchange demand and supply.

Merit and demerit of Flexible exchange rate system

These are some advantages and disadvantages we get from the shift of fixed exchange rate system to flexible rate system.

Gold reserves are not required in flexible exchange rate system

As like in the fixed exchange rate system, flexible exchange rate system does not require a country to put their gold in reserve because the member country are no longer using convertible currencies
International mobility of liquidity. Gold reserves are not a pre required for flexible exchange rate system there has been a tremendous increase in the international mobility of liquidity in terms of gold.

Venture capital

Flexible exchange rate promotes venture capitalism in the foreign exchange rate market trading in international currency itself has emerged as an important economic activity, this helped lead to the expansion in business activities and growth of international money market which is the merit of flexible exchange rate system.

Optimum resource allocation

Flexible exchange rate system needs to be fair exchange rates of different currencies accordingly allocation of resources across different countries of the world is accepted to become more and more optimum and efficient.

Market instability

Uncertainty in flexible exchange rate causes instability in the international money market
Stable monetary policy does not possible in the flexible exchange rate system, going to frequent changes in the exchange rate and value of currencies Central Bank for unit is stable monetary policy of a government.

Bilateral trade agreement

Becomes difficult due to day-to-day fluctuation in the exchange rate, makes bilateral agreement trade difficult to exercise this respect to the growth of international Trade and restrict one country to another country.

External shocks

Flexible exchange rate has enhanced one’s reliability of the domestic economy to external forces which manipulates exchange system.

Conclusion- We hope that by reading this article you will get an insight of what is the Meaning of foreign exchange rate, types of Foreign Exchange rate system its demerit and merits and if you still have droughts feel free to comment and share this post with your friends.

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