Foreign Exchange Market and Exchange Rate Systems

The Foreign Exchange Market is the market in which one country's currency is bought and sold in exchange for another's — it is where the exchange rate (the price of one currency in terms of another, e.g. how many rupees one US dollar costs) is actually determined.

Fixed exchange rate system: the government or central bank officially fixes the exchange rate of the domestic currency against a reference currency (or gold), and commits to maintaining it at that level through market intervention. Advantage: certainty for trade and investment planning. Disadvantage: the central bank must hold and actively use foreign-exchange reserves to defend the fixed rate, and the rate cannot adjust automatically to changing economic conditions.

Flexible (floating) exchange rate system: the exchange rate is left to be determined by the ordinary forces of demand and supply for the currency in the foreign exchange market, without official intervention to hold it at a particular level. Advantage: the rate adjusts automatically to correct trade imbalances over time. Disadvantage: exchange-rate volatility can make trade and investment planning less certain.

Depreciation of a currency means its value falls relative to another currency (more units of the domestic currency are now needed to buy one unit of foreign currency) under a floating system; appreciation means the opposite. Under a fixed system, an official downward or upward change is instead called devaluation or revaluation respectively. …