An Explanation of Exchange Rate Types
Essentially, an exchange rate is a measure of the value of a currency when it is traded for another currency. The most common type of exchange rate is the floating exchange rate, where the value of currencies can vary depending on the law of supply and demand. A floating exchange rate means there is no government intervention to change the value of the currency. However, countries can choose the type of exchange rate they wish to use in order to change the value of that country’s currency.
Fixed or Pegged Exchange Rate
A fixed or pegged exchange rate is an exchange rate that evaluates a currency compared to one currency, several currencies or against a particular measure of value like gold prices. This type of exchange rate is most commonly used to stabilize the value of a currency against the currency which it is compared to.
The Use of Multiple Exchange Rates
The multiple exchange rate system is exactly as it sounds – the use of multiple exchange rates to value a specific currency. Therefore, there are several exchange rates that are used in transactions with foreign countries and each transaction is completed with a different exchange rate. This type of exchange rate system is comprised of a combination of floating and pegged exchange rates. Essentially, this means that non-essential exports and imports use a floating exchange rate that is based on market forces while essential exports and imports use a pegged exchange rate.
Rigidly Fixed Exchange Rate
A rigidly fixed exchange rate is a type of fixed exchange rate that makes use of the gold standard, dollarization and currency boards and unions. When the gold standard is used, the exchange rate is based on the gold reserves in that country. Currency unions are made up of several countries that eliminate their individual currencies and opt to use a single currency – eliminating exchange rates between the currency union members. A currency board system involves the backing of every unit of currency by the same amount of reserve currency – a useful anti-inflation instrument. Dollarization simply means that one country decides to use the currency of another country. As an example, the U.S. dollar is used in Ecuador and Samoa.
Managed Exchange Rate
A managed exchange rate means that the government of a particular country has some influence on exchange rates that otherwise would be floating. This means that the exchange rate can fluctuate but the government prevents any excessive depreciation or appreciation of the currency.
What do you think about these types of exchange rates? Which exchange rate types do you think are beneficial or harmful? Please leave your comments below.