- Exchange rate
- An exchange rate is a price: the price of one currency expressed in terms of units of another currency.
- Foreign exchange market
- The foreign exchange market is the market in which people or firms use one currency to purchase another currency.
Types of exchange rate system
Can you name the three types of exchange rate system?
The three differ in who sets the rate: the market, the central bank, or each at different times.
A floating exchange rate is a policy in which a country lets the foreign exchange market determine the value of its currency.
Can you think of an example?
Sterling floats. When investors sell pounds, the pound falls, and the Bank of England sets interest rates to hit its inflation target rather than to steady the pound.
A managed exchange rate, or soft peg, is a policy in which the market usually sets the rate, but the central bank intervenes when it moves rapidly in one direction.
Can you think of an example?
A central bank lets its currency drift for months. When the currency loses 8 per cent in a single week, the bank buys it with reserves to slow the fall, then steps back.
A fixed exchange rate, or hard peg, is a policy in which the central bank sets a fixed value for the exchange rate, often within a narrow band.
Can you think of an example?
A country fixing its currency at 8 units to the US dollar must buy its own currency with its reserves whenever traders sell it, and raise interest rates if those reserves run low.