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Ask Mint | What determines the exchange rate of one currency against another?

Ask Mint | What determines the exchange rate of one currency against another?
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First Published: Sun, Oct 21 2007. 11 04 PM IST

Shailaja and Manoj K. Singh
Shailaja and Manoj K. Singh
Updated: Sun, Oct 21 2007. 11 04 PM IST
Shailaja and Manoj K. Singh
Comparing the strength of two different currencies in terms of their exchange rates can be more difficult than comparing the strength of two sumo wrestlers. What determines the exchange rate of one currency against the other? Is it their looks? Or the size of their paper? Today, our friend Johnny tries to understand from Jinny how the exchange rates of two different currencies work.
Johnny: Hi Jinny! Last week you didn’t tell me how the exchange rates work. I hope today you will clarify.
Jinny: Of course! Let’s try to understand how exchange rates work. The exchange rate of a currency tells you how much of one currency you can get for another currency.
There are?mainly three kinds of exchange rate regimes that determine how a country manages the exchange rate of its domestic currency against another currency. The first is the pegged or fixed exchange rate regime in which the exchange takes place at a fixed rate. The second is the floating exchange rate regime in which the exchange rate is determined purely by the market forces of demand and supply. And, the third is the pegged float rate or “managed float” regime, which is a mix of fixed and floating rate systems. Under the managed float system, the central bank first decides the target range or band of the exchange rate and then tries to prevent the currency from deviating too much from the target range by managing the demand and supply.
Johnny: Three types of exchange rate regimes! Tell me first how the fixed exchange rate system works.
Jinny: In a fixed exchange rate system, the central bank or the government determines the value at which the exchange of domestic currency against another currency will take place. This could be done by several methods. One method that became popular as the “gold standard” uses gold to back up the value of the currency. This method was used by many countries for fixing the exchange rate of their currency before World War I. In this system, the central bank keeps gold reserves for backing up its domestic currency. This means that any holder of the currency can exchange the paper currency for a prefixed amount of gold kept with the central bank. So, if we assume for the sake of simplicity that one Indian rupee is worth 1gm of gold and one US dollar is worth 40gm of gold, then you can maintain a fixed exchange rate of 40 Indian rupees for one US dollar under the gold standard.
But the gold standard can work only if you continuously maintain the value of your domestic currency in terms of gold by keeping gold reserves. If you fail to do so, your exchange rate will collapse. For this reason, the Bretton Woods system after World War II tried to use a modified version of the gold standard.
Johnny: Bretton Woods system? What’s that?
Jinny: I will try and explain it in brief. Under this system, all participating countries kept US dollars as reserves instead of gold. This system required the US to back up its dollars with reserves of gold. The dollar was linked with gold at the rate of 35 dollars per ounce of gold. This meant that you could exchange your reserves of 35 dollars with one ounce of gold any time from the American central bank. So keeping reserves of US dollars was as good as keeping reserves of gold. You fixed the exchange rate in terms of US dollars on the basis of how much dollar reserves you were maintaining. But this system failed in the 1970s when the US was unable to sustain the value of its currency with gold reserves. After all this, many countries prefer simply using the currency reserves method for maintaining fixed exchange rates.
Johnny: And how does that work?
Jinny: In the currency reserve system, instead of keeping gold reserves or dollar reserves, you simply keep the reserves of any foreign currency against which you want to fix your exchange rate. Say, for instance, that you want to maintain an exchange rate of 40 Indian rupees for one US dollar. Then you need to keep a reserve of one US dollar for every 40 Indian rupees so that your reserve is sufficient to convert all your domestic currency into foreign currency at the fixed rate. In other words, if we suppose that your total domestic currency is worth Rs4 trillion, that is, Rs4,000 billion, then you need to maintain a reserve of $100 billion. Your central bank must have sufficient reserves to manage the demand and supply of the two currencies.
Johnny: I was just wondering, why go to so much trouble? Can’t we simply fix the exchange rate by a diktat?
Jinny: That’s an interesting question. But I want you to apply your own mind. If you are unable to find the answer, you can always ask me...
What: Exchange rate determines how much of one currency can be exchanged for another currency.
How: Exchange rate could be determined by one of the three kinds of systems—fixed, floating and managed floating exchange rate systems.
Who: In case of floating exchange rate, demand and supply decide the exchange rate; in case of fixed or managed float, the government or the central bank decides the rate.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at realsimple@livemint.com.
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First Published: Sun, Oct 21 2007. 11 04 PM IST