A foreign-exchange rate is the price of one currency expressed in terms of another currency. A fixed exchange rate is an exchange rate that does not fluctuate or that changes within a predetermined band. The rate at which the currency is fixed or pegged is called the "par value." A floating or flexible exchange rate is an exchange rate that fluctuates according to market forces.
Although governments do not attempt to prevent fundamental changes in the exchange rate between their own currency and other currency, they typically attempt to maintain orderly trading conditions in the market. A flexible exchange system has a number of advantages:
1 Countries can maintain independent monetary and fiscal policies.
2 Flexible exchange rates permit a smooth adjustment to external shocks.
3 Central banks do not need to maintain large international reserves to defend a fixed exchange rate.
However, a flexible exchange system has several disadvantages. First, exchange rates under a pure version of this system are highly unstable, thereby discouraging the flow of world trade and investment. Second, flexible exchange rates are inherently inflationary, because they remove the external discipline on government economic policy.
A system of fixed exchange rates provides the stability of exchange rates, but it has some disadvantages:
1 The stability of exchange rates may be too rigid to take care of major upheavals such as wars, revolutions, and widespread disasters.
2 Central banks need to maintain large international reserves to defend a fixed exchange rate.
3 Fixed exchange rates may result in destabilizing speculation that causes the exchange rate to "overshoot" its natural equilibrium level. Overshoot (beyond fair value) is natural after devaluation. For example, all three developing-country financial crises since 1980 — the Latin American crisis of the 1980s, the Mexican peso crisis of 1994, and the Asian crisis of 1997-8 — occurred under fixed exchange rate regimes.
Four concepts — appreciation, depreciation, revaluation (upvaluation), and devaluation — are all related to changing the value of a currency. An appreciation is a rise in the value of a currency against other currencies under a floating-rate system. A depreciation is a decrease in the value of a currency against other currencies under a floating-rate system. Under a system of floating rates, a country's exchange rate will appreciate if it raises interest rates to attract capital. Similarly, its exchange rate will "depreciate" if it reduces interest rates.
A revaluation is an official increase in the value of a currency by the government of that currency under a fixed-rate system. A devaluation is an official reduction in the par value of a currency by the government of that currency under a fixed-rate system. Under a system of fixed rates, a country may "devalue" its exchange rate by setting a lower intervention price at which it will intervene in the foreign-exchange market. It may "revalue" or "upvalue" its exchange rate by setting a higher intervention price.
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