The Rate of Exchange
The Rate of Exchange refers to the price of a country’s currency expressed in terms of some other currency.
The Rate of Exchange of the US Dollar to the Maldivian Rufiyaa is $ 01 = Mrf 12.85, managed in a band of +/-20%.
Determination of the Rate of Exchange
The Rate of Exchange is determined by the market forces of demand for and supply of the currency in the foreign exchange market.
Depreciation and Appreciation of Currency
Depreciation refers to a fall in the price of a country’s currency expressed in terms of some other currency.
On the other hand, Appreciation refers to a rise in the price of a country’s currency expressed in terms of some other currency.
When Maldivian citizens want to buy goods and services from USA, we will demand for US Dollar and supply Maldivian Rufiyaa. As a result, the Demand Curve of US Dollar shifts from D to D¹ leading to a fall in the price of Maldivian Rufiyaa and rise in the price of US Dollar.
Types of Exchange Rate
There are three main types of Exchange Rate.
- Fixed Exchange Rate
- Flexible / Floating Exchange Rate
- Managed Exchange Rate
Managing the Rate of Exchange
The central bank of the country attempts to manage the Rate of Exchange in order to smooth out fluctuations. The following are some policies which can be employed in managing the Rate of Exchange.
1. Sales of Foreign Currencies.
A rise in the supply of foreign currency makes the home currency stronger leading to an appreciation.
2. Purchase of Foreign Currencies.
An increased demand for foreign currencies accompanied with the rise in the supply of domestic currency leads to a depreciation of domestic currency.
3. Changes in Interest Rate
A rise in the Interest Rate encourages more people, both local and foreign, to save money at local banks. It increases demand for the local currency leading to an appreciation.
Mean while, a fall in the Interest Rate reduces Marginal Propensity to Save leading to a rise in the supply of local currency in the foreign exchange market which in turn weakens the price of domestic currency.