Question

Define foreign exchange rate. Differentiate between fixed and flexible exchange rates.

Hint:

A fixed exchange rate is pegged to another currency, while a flexible exchange rate is determined by market forces. Both systems have their advantages and disadvantages.

Answer 1

Step 1: Defining Foreign Exchange Rate:
The foreign exchange rate is the price at which one currency can be exchanged for another. It is determined by the demand and supply of currencies in the global market. A higher exchange rate means that a currency is stronger, and it can buy more of another currency. Conversely, a lower exchange rate indicates a weaker currency.
Step 2: Fixed Exchange Rate:
A fixed exchange rate, also known as a pegged exchange rate, is when a country’s currency value is tied or pegged to another major currency, such as the US dollar or the euro. The central bank of the country maintains the currency value within a narrow band, often by intervening in the foreign exchange market to buy or sell its currency. Fixed exchange rates provide stability but can limit the country’s ability to respond to economic changes.
Step 3: Flexible Exchange Rate:
A flexible exchange rate, also known as a floating exchange rate, is when the value of a country’s currency is determined by the market forces of supply and demand without direct government intervention. In this system, the exchange rate fluctuates freely in response to changes in the market. This system allows the currency to adjust automatically to economic conditions but can lead to higher volatility in exchange rates.
Step 4: Final Conclusion:
Foreign exchange rates determine the value of one currency relative to another. Fixed exchange rates provide stability but limit flexibility, while flexible exchange rates allow currencies to fluctuate based on market conditions, offering more adaptability but with potential for greater volatility.