Exchange Rate and its Types

Concept of exchange rate

The exchange rate can be defined as the rate at which one country's currency is exchanged with the currency of another country. For instance, if the exchange rate between the US dollar and Nepalese Rupees is $1 = Rs. 118, this tells us that we give up 118 Nepalese Rupees for each US dollar. This is because foreign currencies are exchanged in the foreign exchange market.

According to Crowther, "The rate of exchange measures the number of units of one currency which will change in the foreign exchange market for another."

Thus, the exchange rate is the value of one currency in terms of another currency. The foreign exchange rate is the critical determinant of the prices of exports and imports in international trade. The change in the foreign exchange rate directly impacts the external trade balance and domestic economy. It provides us a basis for understanding the causes and impacts of fluctuation in the foreign exchange rate on the performance of an economy. It is determined by the demand for and supply of currency in the foreign exchange market. If the demand for the currency increases, the exchange rate will rise. On the other hand, if the supply of currency increases, the exchange rate will fall.

Types of exchange rate

The various types of exchange rates are as follows:

1. Flexible exchange rate: The flexible exchange rate system is one in which rates of currency or exchange rate are determined by the demand and supply market forces. It is also known as the floating exchange rate system. In the flexible exchange rate system, the government does not make any interference. For example, the exchange rate system between Nepal and the USA is flexible. Most of the world's countries have adopted a flexible exchange rate system.

2. Fixed exchange rate: The fixed exchange rate system is one in which the currency or exchange rate is fixed in terms of another currency. This is also known as the pegged exchange rate system. It does not fluctuate with changes in the demand and supply of foreign currency. The exchange rate system between Nepal and India is a fixed exchange rate system.

3. Forward exchange rate: The rate of exchange at which a futures contract for foreign currency is made is called the forward exchange rate. In other words, the forward rate of exchange is settled now. However, the actual sales and purchase of foreign currency occur in the future.

4. Multiple exchange rate: The system in which a country adopts more than one exchange rate for its currency is called multiple exchange rate. According to this system, different exchange rates are fixed for importers, exporters, and different countries.

5. Two-tier exchange rate system: It is a multiple exchange rate system. In this system, a country maintains two rates, a higher rate for commercial transactions and a lower rate for capital transactions.