International
trade involves not only the exchange of commodities, but also
exchange of currencies. The foreign
exchange market consists of all those consumers, firms and governments
wishing to buy foreign exchange and all the suppliers of foreign currencies.
Foreign exchange rate is the
price of a foreign currency, that is, the value of a currency is measured in
terms of other currency. [1 US Dollar = 15.42 Maldives Rufiyaa]
Free, fluctuating or floating exchange rates
means that the price of one currency in terms of another is determined by the
forces of supply and demand operating without any official interference.
The main advantage is that, it provides a kind of automatic mechanism for
keeping the balance of payments in equilibrium. Secondly it stops the
exchange rate being a target, so government will not have to introduce measures
to protect the value of the currency at a fixed rate which might threaten its
other objectives.
A
major disadvantage of free or
floating rates is that they add a further element of uncertainty to
international trading. The traders have to accept a high degree of risk –
they have to watch the foreign price of the commodity and the price of the
foreign currency. [Forward market reduces this risk – They will a quote a fixed
price for foreign currencies for future delivery.]
Market
forces determine the exchange rates, but at times central banks try to
influence the market rates, these are known as Managed exchange rate. This is done by adjusting
interest rates to flow funds in and out of country. It is capable of
moving easily and quickly to correct the imbalances.
In
Fixed exchange rate system the
countries fix the values of their currencies in terms of some common
standard. In order to maintain the currency value fixed, the monetary
authorities of a country must stand ready to buy and sell the currency at the
fixed prices.
The
major advantage is that it
removes the uncertainty with floating rate, so negotiation for long term
contracts are possible.
The
major disadvantage is that the
burden of adjusting a balance of payment disequilibrium will be on the domestic
economy. If a country experience persistent deficit, would soon exhaust
its foreign currency reserve.
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