Exchange rates are the price of one nation's currency in terms of another nation's currency, or the rate at which one currency is traded for another. For example, an exchange rate of two U.S. dollars per British pound means that the price of a British pound is two dollars.

Exchange rates are key to international trade, exports and imports flowing among countries. First and foremost, the trading of goods and services requires the exchange of currencies. When buyers in the United States purchase goods from England, they need ultimately need British pounds to complete the transaction. However, the resulting exchange rate also affects exports and imports, which is where exchange rate policies come into play.

Controlling Rates

If the United States, for example, wants to increase the exchange rate for British pounds from 2 dollars per pound to 3 dollars per pound, it can do so by increasing the quantity of U.S. dollars in circulation. With more U.S. dollars, the value of each is less and more are needed to purchase one British pound. Of course, a decrease in the exchange rate, say from 2 dollars per pound to 1 dollar per pound, can be had by decreasing the quantity of U.S. dollars in circulation. The same results can also be obtained with opposite changes in the quantity of British pounds in circulation.

However, rather than an economy-wide money supply change, the change is usually targeted at a particular exchange rate. The United States government, for example, can change the dollar-pound exchange rate by buying or selling British pounds in the dollar-pound foreign exchange market. In so doing, the quantity of dollars either increases (when buying pounds) or decreases (when selling pounds).

Like other government policies actions, exchange rate controls have secondary consequences. Changes in the money supply are bound to affect the performance and stability of domestic economy, especially the inflation rate.

Flexible Exchange Rate

A flexible exchange rate means that a country is NOT trying to manipulate currency prices to achieve some change in the exports or imports. This policy is based on the presumption that the free interplay of market forces is most likely to generate a desireable pattern of international trade. However, if a desireable pattern is not achieved, then tariffs, import quotas, or other trade policies might be enacted. It also provides a benchmark for the analysis of other policies.

Fixed Exchange Rate

To fix an exchange rate, government must be willing to buy and sell currency in the foreign exchange market in whatever amounts are necessary to keep the exchange rate fixed at a specified level. A fixed exchange rate typically disrupts the flow of trade, the balance of trade, and the balance of payments for a country. But in many cases, this is exactly what a country is seeking to do.

Setting the exchange rate at a low level, below the flexible exchange rate, encourages exports and discourages imports, which increases net exports. Setting the exchange rate at a high level, in contrast, discourages exports and encourages imports, which decreases net exports. Moving from a higher to lower exchange rate is termed devaluation or depreciation of currency. Moving from a lower to higher exchange rate is termed revaluation or appreciation of currency.

Managed Flexible Exchange Rate

Most nations of the world currently use a managed flexible exchange rate policy. With this alternative an exchange rate is free to rise and fall, but it is subject to government control if it moves too high or too low. With managed float, the government steps into the foreign exchange market and buys or and sells whatever currency is necessary keep the exchange rate within desired limits.