This article looks at the history and valuation of the foreign exchange rate.
The foreign exchange rate determinants have changed since the introduction of the gold standard system during 1875. It moved from the gold system to the Bretton Woods system, and finally during the 1970s the US made the decision to put an end to being the international reserve currency.
The Current Foreign Exchange Rate
After the breakdown of the Bretton Woods system, the countries affected decided to make use of the floating foreign exchange rate system which was agreed upon during 1976 by the Jamaica agreement. This caused the gold standard to be abolished completely. This does not imply that all governments decided to make use of this floating system. Most governments opt for one of three available methods of determining their exchange rate. These three methods include dollarization, managed floating and the fixed or pegged rate.
Fixing occurs when a country fixes its domestic rate to that of a foreign currency. This is normally done to give their currency more stability than a floating rate would. Pegging the rate allows the country’s currency to be exchanged at a rate that has been fixed to a single or a group of foreign currencies. This causes the currency to change only when the currency it is fixed to changes.
The problem with this method is that the country that has done the pegging is at the mercy of the economic situation in the pegged country. The pegged currency may appreciate substantially and this may not be what the other country wants at all. China fixed its currency to the US dollar for a number of years during 1997 and 2005.
This happens when a country makes the decision not to print its own currency, but instead adopts another country’s currency as its own. This may be a good idea for a country as it is then seen to have a stable economy and will attract investors, however the downside to this is that it will no longer be able to make any monetary policy of its own or print money.
With this system a country’s currency value will change based on the laws of supply and demand. When there is high demand for a particular currency, the value of that currency will increase. Likewise, if there is a decrease in demand, the currency will devalue.
The central bank or the government has the opportunity to intervene if the country is experiencing severe foreign exchange rate fluctuations. The government may decide to increase the interest rates linked to short-term borrowings in order to stabilise a depreciating currency. As soon as the interest rates increase, the currency value will increase. This is a simple way for the government to control the foreign currency rates. There are several other tools that central banks may use to stabilise and manage the currency.
These are the basic systems of currency control that you should be aware of if you wish to trade in the currency market. There are many other factors that affect foreign exchange rates and the number of participants in this market may affect it.
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