Exchange rate is a term that is used to describe the value of one currency that is traded for another. There are generally two systems that determine these rates. One system, known as the fixed exchange rate, refers to a trading rate that remains the same despite market factors.
Currency is bought and sold like other goods. Some people buy and sell currency because they are attempting to make a profit from doing so. Other people buy and sell currency because they may need a different currency to conduct different transactions. When there is a fixed exchange rate, a person will receive the same amounts each time he buys and each time he sells those currencies.
A fixed exchange rate is commonly referred to as a pegged exchange rate. Generally, this system works when countries decide to fix, or peg, their currency to the trade of a major currency, such as the United States Dollar (USD) or the Euro. The weaker currency is referred to as a pegged currency. Major currencies generally are not pegged; they float.
When there is a fixed exchange rate, it is set by the authority that oversees a country's monetary system. In many cases, these authorities are referred to as central banks. Although fixed exchange rates suggest a degree of permanence, the rates can be adjusted. In some instances, adjustment or complete abandonment of a fixed exchange rate may become necessary.
The motives for deciding upon a fixed rate system are often well-intentioned. A country may view the decision as a way to provide stability, which they may assume will help to attract investments. This system, however, has been notorious for resulting in problems.
Maintaining a fixed exchange rate requires a country to have a sufficient amount of foreign currency. This money is referred to as a country's foreign reserves. When a country has insufficient foreign reserves, it will eventually lack the money to buy its own currency in exchange for the currency that it is pegged to. This results in the country's currency being overvalued, or inflated.
This situation can be illustrated by tourism. When tourists go to a foreign country, they are commonly required to exchange their national currency for the currency that is used in the country that they are visiting. If there is a fixed exchange rate, they can expect to get the same amount for exchanging their national currency each time an exchange is made. When their visits are over, they will generally want to sell the country's currency back and retrieve an equivalent amount of their national currency. When a country has insufficient foreign reserves, they will be incapable of buying their money back.