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Exchange Rate Notes

An exchange rate is the price of one country's currency in terms of another's, indicating how much foreign currency can be obtained with local currency. There are several types of exchange rates, including fixed, flexible, managed float, and dual rates, each with its own advantages and disadvantages. The determination of exchange rates is influenced by factors such as demand and supply, balance of payments, interest rate differentials, inflation rates, and government policies.

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10 views3 pages

Exchange Rate Notes

An exchange rate is the price of one country's currency in terms of another's, indicating how much foreign currency can be obtained with local currency. There are several types of exchange rates, including fixed, flexible, managed float, and dual rates, each with its own advantages and disadvantages. The determination of exchange rates is influenced by factors such as demand and supply, balance of payments, interest rate differentials, inflation rates, and government policies.

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Exchange Rate: Meaning, Types and Determination

1. Meaning of Exchange Rate

An exchange rate is the price of one country's currency in terms of another country's currency.

It shows how much of foreign currency you can get with one unit of your local currency.

Example: If 1 USD = NGN 150, it means you need 150 Naira to get 1 US Dollar.

2. Types of Exchange Rate

Exchange rates can be classified based on how they are determined and whether they are allowed to

fluctuate. The main types are:

a. Fixed Exchange Rate (Pegged Rate)

- The government or central bank fixes the value of the currency to another currency or a basket of

currencies.

- It does not fluctuate freely in the foreign exchange market.

Example: If the Nigerian government fixes the rate at NGN 200 = $1, it remains constant unless officially

changed.

Advantages:

- Stability in international trade

- Encourages foreign investment

Disadvantages:

- May lead to black market operations

- Difficult to maintain if foreign reserves are low

b. Flexible or Floating Exchange Rate


Exchange Rate: Meaning, Types and Determination

- Determined by market forces (demand and supply of foreign exchange) without government intervention.

- Rate fluctuates daily.

Advantages:

- Adjusts automatically to trade balances

- Reduces need for large foreign reserves

Disadvantages:

- May cause instability in trade

- Can lead to inflation

c. Managed Float (or Dirty Float)

- A combination of fixed and floating exchange rates.

- Government or central bank occasionally intervenes to stabilize the currency.

d. Dual Exchange Rate

- The government maintains two different rates: one official and one for specific sectors or purposes.

- Often used in developing countries to control imports and encourage exports.

3. Determination of Exchange Rate

The exchange rate can be determined through:

a. Demand and Supply of Foreign Currency

- High demand for a foreign currency = its value rises (local currency depreciates)

- High supply of a foreign currency = its value falls (local currency appreciates)
Exchange Rate: Meaning, Types and Determination

b. Balance of Payments (BOP)

- A surplus in BOP = appreciation of currency (more foreign currency flows in)

- A deficit = depreciation of currency (more demand for foreign currency)

c. Interest Rate Differentials

- Higher interest rates in a country attract foreign investors = appreciation of currency

d. Inflation Rate

- Lower inflation = stronger currency

- Higher inflation = weaker currency

e. Government Policies

- Central bank interventions, devaluation, or revaluation policies can also affect the exchange rate

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