Meaning and Types of Exchange Rate

Meaning of Exchange Rate

The foreign exchange market is an organisational setting within which individuals, business firms, banks, etc. buy and sell foreign currency. It has no centralised meeting place and is not limited to one country.

The exchange rate is the price of a unit of foreign currency that may be bought for a unit of domestic currency. It is simply the price at which one currency can be traded for another. If the U.S. dollar sells for ₦9,200, this defines the exchange rate between the US dollar and the Nigerian naira.

Types of Exchange Rate

There are basically two types of exchange rate, which are:

Fixed Exchange Rate

In a fixed exchange rate regime, the external value of a country’s currency is determined by explicit government policy and fixed at a certain amount of the domestic currency per unit of foreign currency. Periodic changes in the exchange rate by government are described as devaluation or revaluation. Devaluation refers to the deliberate reduction in the external value of a domestic currency. On the other hand, revaluation is a deliberate increase in the value of a country’s currency relative to other currencies. The main advantages of fixed exchange rate are:

1. It removes the uncertainty associated with the flexible exchange rate regime and brings stability.
2. It also indirectly imposes some anti-inflationary discipline on policy makers since there is the need to maintain and defend the exchange rate.

In contrast, the main disadvantages are that the currency may stay overvalued or under-valued; the system may create a parallel foreign exchange market referred to as black market

Flexible Exchange Rate

Under the flexible or freely-floating exchange rate regime, the external value of a country’s currency is determined by the forces of demand and supply. The exchange rate for the country is the result of the interaction between the demand and supply of foreign currency. In a flexible exchange rate regime, variations in the exchange rate are referred to as depreciation or appreciation. Appreciation means the value of a country’s domestic currency has increased relative to foreign currencies. Depreciation refers to a fall in the value of a country’s domestic currency relative to foreign currencies.