The foreign exchange rate between two currencies simply refers to how much of one currency you would need to purchase the other. Consider, for example, that the foreign exchange rate of the Singapore Dollar (SGD) was 0.75 US Dollars (USD). This means that you would need 0.75 USD to purchase 1 SGD.
A Bit of Foreign Exchange Rate History
The free floating system that exists today is relatively young. Prior to 1944 a country’s currency was fixed to that country’s gold reserves. This system was replaced in 1944 when the Bretton Woods agreement was reached, which effectively pegged every country’s foreign exchange rate to the USD. This system lasted until 1971. The United States was borrowing at a high rate, and had high inflation, which led some Bretton Woods participants to question the true value of the dollar. To avoid a possible run on the US gold reserves, (which many believed the US could not meet if called on to do so), the country declared that it would float the USD against other currencies, creating a natural and free floating exchange rate system.
Sometimes a nation will peg its currency to that of another. China, for example, pegged its currency to the USD for the decade preceding 2005. In pegging the foreign exchange rate of its currency to the USD China was able to increase investor confidence in the nation, which led to a rapid expansion of the country’s export sector. The pegging also served to stabilize China’s volatile inflation rate. Today China is the second largest economy in the world, and many believe this would not have been achievable without this currency manipulation.
What is Devaulation?
Often a nation will also use its exchange rate to affect its economic situation. For example, if a country’s central bank sells large amounts of its currency, this will devalue the currency and lower its exchange rate against others. This will make exports cheaper, and can promote trade international trade, benefiting the nation. Alternatively a country may buy large amounts of its own currency, which will raise its value and make imports cheaper, increasing the earnings potential of companies in that country.
Why Don’t Countries Just Print Money?
If a country needs to purchase things from abroad then at first glance it makes sense to just print money to do so. In reality however, this does not work, and can have seriously detrimental effects on the economy of the nation. Consider basic supply and demand. If the supply of something falls, its value goes up. Conversely, if the supply of something increases, its value falls. Printing money leads to a fall in value of that currency, in other words, inflation. That country’s foreign exchange rate will fall, and more of its currency will be required buy goods abroad. Not only this, but domestic prices will increase, to factor in falling currency value. An example of this is the Zimbabwean hyperinflation. After its independence Zimbabwe started to print money to fund conflict with other African nations. As a result the Zimbabwe dollar went from being worth more than the USD in 1980, to $1 costing $Z2,621,984,228 in November 2008.