Currency is regarded as a general accepted mean of exchange. While engaging in international trade the individuals of different economies have to transact currency among each other. Exchange rate is used as a tool to determine the rate at which the currency of one country can be exchanged for the currency of another country. In simple words we can say that exchange rate determines the price of a particular currency with regard to some other currency. The stability of exchange rate is one of the most important priorities of most of the economies.
There are two exchange rate systems that determine the value of a particular currency with regard to another currency. These two exchange rate systems are floating rate system and fixed rate system. In fixed rate system the government or central bank appoints a fixed tied exchange rate with regard to some other country’s currency. Sometimes the fixed rate tied by the government or central bank is settled on the price of gold. Fixed exchange rate also known as pegged exchange rate is used to stabilize country’s currency against other currency with which the country’s currency is pegged. The fixed rate of currency can also be used as a weapon against inflation. This type of exchange rate can also harm economy as it demoralizes governments to develop domestic monetary policy to enhance macroeconomic performance and stability.
Floating exchange rate that is also known as fluctuating exchange rate allows a currency to fluctuate with regard to changing trends in foreign exchange market. The currency whose exchange rate is determined on the basis of floating exchange rate is referred to as floating currency. The benefit associated with the floating exchange rate is that it adjusts itself against foreign business cycle and economic shocks. But floating exchange rate may encounter stability and certainty issues.
The theory of purchasing power parity (PPP) is commonly used to determine exchange rate of a particular currency. This theory implies that the exchange rate can be determined by comparing relative price levels of two countries. The essence of this theory holds that in order to find out exchange rate the price of similar commodity must be compared within two different economies. Beside purchasing power parity theory other determinants that are used to determine exchange rate may include; differentials in inflation, differentials in interest rate, current account deficits, public debt, terms of trade and political stability and economic performance. The determination of exchange rate using interest rate is supported by the theory named interest rate parity theory.