Currency for a Currency: Exchange rate

An exchange rate is the rate at which one country's currency maybe exchanged for that of another. Exchange rates have been governed in the recent years primarily by the forces of supply and demand.

The demand for a currency may come from sources such as importers, exporters, tourists, the military, private investors or international corporations. For instance, if an American businessman imports automobiles from a Japanese exporter, he may pay the Japanese exporter in Japanese yen. If the total demand for yen in the money market is greater than that of US dollars, the value of the yen tends to rise.

Until recently, governments preferred to keep exchange rates stable. Under the gold standard, which prevailed from the 1870s to 1914, the value of each currency exceeded the supply, banks shipped gold bullions to satisfy their client's requirements for the scarce currency. A flow of gold into the country increased its money supply, raising prices and making its goods more expensive. This, in turn reduced foreign demand for its currency.

After World War I, the gold standard was replaced by other devices, some of which adversely affected international trade. The International Monetary Fund was created in 1944 in an effort to stabilize exchange rates without interfering with the healthy growth of trade. Currency values were still defined in terms of gold, although the place of place of gold in international transaction was, to a large extent, taken by the dollar.

In 1971 the United States left the gold standard, announcing that it would no longer stand ready to convert the dollars by foreign central banks into gold. For a time it tried to maintain the dollar at a fixed exchange rate with other currencies but abandoned the effort in 1973. Since then, all major industrial countries have allowed their currencies to "float" - that is to find their values in relation to each other, except for occasional intervention by Central Banks to prevent large short-term fluctuations.

Various arguments are advanced for and against the system of floating rates. Some economists favor floating rates for many of the same reasons that they favor a free market system. They believe that currency prices be determined by supply and demand. Bankers and international traders, on the other hand, tend to prefer fixed exchange rates on which they can rely when doing business. Floating rates may fluctuate sharply over the short period as a result of speculations.