Exchange rates?

In simple words, Exchange rate is the price of a nations currency in terms of another
currency.
Various method of how the exchange rate is evaluated:
1) Fixed Exchange rates
2) Floating Exchange Rates

Fixed Exchange rates:

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate
regime where a currency's value is fixed against the value of another single currency, to
a basket of other currencies, or to another measure of value, such as gold. A fixed exchange
rate is usually used to stabilize the value of a currency against the currency it is pegged to.
This makes trade and investments between the two currency areas easier and more
predictable, and is especially useful for small economies in which external trade forms a large
part of their GDP. However, as the reference value rises and falls, so does the currency
pegged to it.
Types of fixed exchange rate systems
The gold standard
Under the gold standard, a countrys government declares that it will exchange its currency
for a certain weight in gold. In a pure gold standard, a countrys government declares that it
will freely exchange currency for actual gold at the designated exchange rate. This "rule of
exchange allows anyone to go the central bank and exchange coins or currency for pure gold
or vice versa. The gold standard works on the assumption that there are no restrictions on
capital movements or export of gold by private citizens across countries.
Because the central bank must always be prepared to give out gold in exchange for coin and
currency upon demand, it must maintain gold reserves.

Reserve currency standard

In a reserve currency system, the currency of another country performs the functions that
gold has in a gold standard. A country fixes its own currency value to a unit of another
countrys currency, generally a currency that is prominently used in international transactions
or is the currency of a major trading partner. For example, suppose India decided to fix its
currency to the dollar at the exchange rate E/$ = 45.0. To maintain this fixed exchange rate,
the Reserve Bank of India would need to hold dollars on reserve and stand ready to exchange
rupees for dollars (or dollars for rupees) on demand at the specified exchange rate. In the gold
standard the central bank held gold to exchange for its own currency, with a reserve currency
standard it must hold a stock of the reserve currency.
Gold exchange standard
The fixed exchange rate system set up after World War II was a gold-exchange standard, as
was the system that prevailed between 1920 and the early 1930s. A gold exchange standard is
a mixture of a reserve currency standard and a gold standard.
Unlike the gold standard, the central bank of the reserve country does not exchange gold for
currency with the general public, only with other central banks.
But there a few points that need to be taken in to consideration: The Govt in a affixed
exchange syaytem, from time to time, overvalues or undervalues its own currency.

Mechanisms:
1) Open Market Trading
Typically an open market mechanism is used, where the central bank of a country remains
committed at all times to buy and sell its currency at a fixed price. Typically, a government
wanting to maintain a fixed exchange rate does so by either buying or selling its own
currency on the open market. This is one reason governments maintain reserves of foreign
currencies. If, for example, it is determined that the value of a single unit of local currency is
equal to US$3, the central bank will have to ensure that it can supply the market with those
dollars. In order to maintain the rate, the central bank must keep a high level of foreign
reserves.
2) Fiat

Another, less used means of maintaining a fixed exchange rate is by simply making it illegal
to trade currency at any other rate. This is difficult to enforce and often leads to a black
market in foreign currency. Nonetheless, some countries are highly successful at using this
method due to government monopolies over all money conversion. This was the method
employed by the Chinese government to maintain a currency peg or tightly banded float
against the US dollar. Throughout the 1990s, China was highly successful at maintaining a
currency peg using a government monopoly over all currency conversion between the yuan
and other currencies.
Eg of operations under fixed exchange rate system:
A situation when it undervalues its currency:

In the above diagram, it can be seen that the Govt has undervalued the Indian currency. This
is done when the govt wants to raise the exports of the country. For eg. An American who
gets Indian goods of RS.50 in dollar, will not get Indian goods of Rs. 60 at the same price. So
this definitely has to affect the exports of the country in a positive manner.
When the Govt. overvalues Its our currency:

There are times when the Govt can overvalue its currency. Like in the above graph the
fundamental rate was rs50=1$. Then the Govt, overvalued its currency by turning the
exchange ratio to rs40=1$. With such measures, the exports of the country will decrease and a
rise in imports can be seen.

Flexible Exchange rate System:

1.

A flexible exchange-rate system is a monetary system that allows the exchange rate to
be determined by supply and demand. Unlike the fixed rate, a floating exchange rate is
determined by the private market through supply and demand. A floating rate is often termed
"self-correcting," as any differences in supply and demand will automatically be corrected in
the market. Look at this simplified model: if demand for a currency is low, its value will
decrease, thus making imported goods more expensive and stimulating demand for local
goods and services. This in turn will generate more jobs, causing an auto-correction in the
market. A floating exchange rate is constantly changing.
If the rates are based on the demand and supply of a currency, who creates this deamd and
who supplies?
Deamnd is usually created by the importers, exportes or anyone who is in need of a particular
currency, and the one who supplies. So basically, if you are an importer, you are on the
demand side and if you are an exporter, you are on the supply side.
While it is not only the demand and supply of currencies that affects it value in the
international market:
1) Balance of payments:
It is a record of the value of transactions between residents of a country with outsiders. In
other words it represents the demand and supply od foreign exchange which will determine
the value of a currency.
2) Inflation

This means rise in the price of the domestic commodities. With increase in price,the exports
maybe affected as it will cease to be competitive. To give an example- if both India and Us
experience 7% inflation, the rate of exchange will not change. If on the other hand India has
15% inflation and US has 5% inflation, then obviously the Indian rupee will depreciate by
10%.
3) Interest Rates
Interest rates have huge impacts on the exchange rates as they affect the amount of
investments that individuals make in different countries. If in Canada 2% interest rate is
offered and in America 12% is offered. Then, the people will convert their currency into US$
and invest in US, where they are offered higher returns. Thus, the demand for US currency
increases with the supply of the Canadian currency.
4) Money Supply
An Increase in the money supply in a country ultimately increases the supply of the currency
in the international market. Due to the increased supply of the currency, its value depreciated
in the market.
5) Political Factors
Political stability induces confidence in the investors and encourages capital inflow in the
country. This may be lead to higher FDI in the country.

Managed float regime

Managed float regime is the current international financial environment in which exchange
ratesfluctuate from day to day, but central banks attempt to influence their countries'exchange
rates by buyingand selling currencies. It is also known as a dirty float.

Generally the central bank will set a range which its currency's value may freely float
between. If the currency drops below the range's floor or grows beyond the range's
ceiling, the central bank takes action to bring the currency's value back within range.

Management by the central bank generally takes the form of buying or selling large
lots of its currency in order to provide price support or resistance. For example, if a
currency is valued above its range, the central bank will sell some of its currency it

has in reserve. By putting more of its currency in circulation, the central bank will
decrease the currency's value.

A managed float regime is a hybrid of fixed and floating regimes. A managed float
captures the benefits of floating regimes while allowing central banks to intervene and
minimize the risk of harmful effects due to radical currency fluctuations that are a
characteristic of floating regimes.

This is why a managed float is so appealing. A country can obtain the benefits of a
free floating system but still has the option to intervene and minimize the risks
associated with a free floating currency. If a currency's value increases or decreases
too rapidly, the central bank can intervene and minimize any harmful effects that
might result from the radical fluctuation.