Exchange rate

Updated: Aug 20, 2021

The price (rate) at which one currency is exchanged for another currency, for gold or special drawing rights. These transactions are carried out spot or forward in the foreign exchange markets. The actual rate at any one time is determined by supply and demand conditions for the relevant currencies in the market. These in turn would depend on the balance of payments deficits or surpluses of the relevant economies and the demand for the currencies to meet obligations and expectations about the future movements in the rate. If there were no government control over the exchange market (such as the U.K. exercises through the exchange equilization account), there would be an entirely free or floating exchange rate in operation. With a freely floating system, no gold and foreign exchange reserves would be required as the exchange rate would adjust itself until the supply and demand for the currencies were brought into balance. Under the rules of the International Monetary Fund, established at the Bretton Woods Conference towards the end of the Second World War, exchange rates were fixed at a par value in relation to the dollar and fluctuations around this value were confined within a ± l per cent band. The dollar itself was not subject to this restriction, because the U.S. government was committed to buying gold on demand at a fixed rate of $35·0875 per ounce. However, in August 1971 the United States suspended the convertibility of the dollar into gold and other currencies, imposed a 10 per cent surcharge on imports and took other measures aimed at eliminating its balance-of­payments deficit. There followed a period during which some major currencies were allowed to float but subject to exchange control regulations to keep the exchange rate movements within limits (a ‘dirty float‘). In December 1971, the ‘Group of Ten’ in the I.M.F. meeting at the Smithsonian Institute, Washington, agreed to a realignment of exchange rates which left the dollar devalued by about 5 per cent against an average of all other currencies in exchange for a rise in the dollar price of gold to $38 per ounce and the removal of the import surcharge. In addition, it was agreed that the margin of permitted fluctuations should be ± 2·25 per cent.

Reference: The Penguin Dictionary of Economics, 3rd edt.

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James Knight
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James is the Editor of Education for Invezz, where he covers topics from across the financial world, from the stock market, to cryptocurrency, to macroeconomic markets.... read more.