What Determines The Rate Of Exchange?

February 1, 2011  |  

Pegged currency and floating currency are the two main systems that come into play while referring to the rate of exchange. While the former system is determined by the market where the price of the currency is set at the price that the buyers are willing to pay for it, the latter system is always set an maintained by the government and the rates of exchange remain constant and are estimated with a target currency taken as the base, which more often than not is usually the US dollar.

Pegged currency depends on the forces of market supply and demand that is controlled by a number of other factors like inflation, foreign investments, import to export ratios and a plethora of many other economic factors. Stable and mature economic markets in countries like Canada, Great Britain and Canada use the floating currency rate exchange. They have a more stable financial environment where the market automatically corrects the rate of exchange to reflect economic forces and inflation. In the event of economic instability, the floating rates exchange discourages financial investments and investors may become the victims of debilitating inflation and extreme changes in the currency exchanges rates.

The government tries to keep the pegged currency exchange rates stable by allowing national banks to hold huge reserves of foreign currency to minimize changes in demand and supply. Potentially immature and unstable economies usually employ pegged rates of exchange. They can avoid inflation and financial panic in the market by resorting to the use of a floating peg which prevents day to day fluctuation.

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