Rates of Exchange

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Rates of Exchange

The exchange rate is the price of one currency in terms of another. Sometimes the exchange rate is defined as the price of the foreign currency (also called "foreign exchange") in terms of domestic currency. For example, if the U.S. dollar is the domestic and the British pound the foreign currency, the rate could be $2 per pound; in this formulation, the exchange rate is also called the "foreign-exchange rate." Other times, the exchange rate is expressed as the price of the domestic currency in terms of the foreign currency, in which case the rate is called the "exchange value" of the domestic currency. Continuing with the example, the exchange value of the dollar is 0.5 pound.

As the exchange value of a currency increases (or decreases), the currency "appreciates" or is "revalued" (or "depreciates" or is "devalued"): the currency is worth more (or less) in terms of the other currency.


The exchange rate is used to convert a price or value from denomination in one currency to denomination in another. A higher exchange value of the U.S. dollar implies that foreign goods, services, and capital assets are cheaper for Americans, whereas U.S. goods, services, and capital assets are more expensive for foreigners.

Suppose the dollar value of the items that Americans want to buy from foreigners exceeds the dollar value of the items that foreigners want to buy from Americans. This excess pushes down the exchange value of the dollar (if the exchange rate is free to vary) or creates a U.S. balance-of-payments deficit (if the exchange value of the dollar cannot go lower), or perhaps a combination of the two (if the exchange can vary somewhat). An excess in the opposite direction either pulls up the exchange value of the dollar or creates a U.S. balance-of-payments surplus, or some combination. All this activity takes place in the foreign-exchange market (sometimes called simply the "exchange market"), where foreign currency (foreign exchange) is traded for domestic currency.


There are three basic types of exchange-rate systems. First, an exchange rate can be floating. This means that the exchange value of the domestic currency moves to equilibrate domestic purchases of foreign items and foreign purchases of domestic items. Second, the exchange rate can have upper and lower limits imposed by the central bank, or by the treasury acting as a central bank. The official institution passively stands ready to buy or sell a foreign asset (gold, silver, or foreign exchange) for domestic currency at a fixed price. In this situation, the country is said to have a pegged-rate system.

How are the limits to the exchange rate imposed? Under a gold standard, countries buy and sell gold at a fixed price in domestic currency. The ratio of the countries' official prices of gold is the "mint parity" between the two currencies. Because of costs of transferring gold, the exchange rate varies between a "gold-export point" (where the exchange value of the domestic currency is at its lowest level and the country has a balance-of-payments deficit) and a "gold-import point" (where the exchange value is at its highest level and the country has a surplus). The difference between the gold points is called the "gold-point spread."

Another way is "passive exchange-rate intervention": the country's central bank buys foreign currency (for example, the U.S. dollar) at a dollar-buying (analogous to gold-import) point and sells it at a dollar-selling (gold-export) point. This pegging can be done independently by the country or via internationally imposed rules such as those of the International Monetary Fund, which required countries to maintain their exchange rate against the dollar within 1 percent of a "par value," analogous to mint parity, with the difference between the buying and selling points called the "parity band."

The third type of exchange-rate system is exchange control. In this situation a country suppresses a deficit without losing gold or foreign exchange and without a currency devaluation by using government fiat (such as licenses to purchase foreign items) to reduce the demand for foreign exchange so that the demand is not greater than the available supply.


Determinants of the level of the exchange rate under a floating rate serve as determinants of the amount of balance-of-payments deficit or surplus under a pegged rate. Some determinants affect individual items in the balance of payments. Examples are improvements in productivity that make a country's goods and services more competitive, resulting in a currency appreciation (or surplus), and increased government spending on war abroad, involving a currency depreciation (or deficit). Another determinant is the country's money-supply/real-income ratio compared to that of its principal trading partners. An increase in the money supply increases spending on foreign items, except to the extent that there is an increase in money demand (for example, from higher real income) to soak up the money; thus the currency depreciates, or there is a deficit.


METALLIC STANDARDS From 1450 to 1914 metallic standards were the norm—originally silver, then gold in the late nineteenth century. The spread between silver points or gold points was very great in early centuries, but as time went on, improvements in transportation and communication reduced the spread and therefore the variability of the exchange rate. For example, it has been calculated that the dollar-pound exchange rate averaged 5 percent from parity (about $4.87 per pound) in 1791 to 1800, 0.33 percent in 1881 to 1890, and less than 0.15 percent in 1901 to 1910.

Currency depreciations to gold-export points and consequent balance-of-payments deficits occurred due to foreign wars and civil wars, government expenditure on wars and extravagant items, and poor harvests. Until the eighteenth century currencies would occasionally depreciate in a jump beyond the gold-export point by governments reducing the metal content of the domestic currency, thus altering the mint parity so that the exchange rate (price of foreign currency) increased. Terminated at the onset of World War I, the gold standard was resurrected from the mid-1920s to the early 1930s.

INTERNATIONAL MONETARY FUND SYSTEM The International Monetary Fund system was in effect from 1947 to 1971, and again (after an interlude in the second half of 1971) from 1971 to early 1973. In the 1971 to 1973 experience, the parity band was increased from 1 to 2.25 percent. The system permitted countries to change the par value—devaluing their currencies in the face of serious deficits, revaluing in the face of surpluses. For example, the United Kingdom coped with deficits by depreciating the pound from $4.03 to $2.80 in 1949, then to $2.40 in 1967.

INDEPENDENT PEGGING Independent pegging was conspicuous in the late nineteenth century until World War I, when small countries or colonies pegged their currencies to the currency of a large country or the home country. The phenomenon also occurred during wartime, for example during each World War, when the United Kingdom pegged the pound to the dollar. Some countries adopted independent pegging after the International Monetary Fund system was terminated in 1973.

FLOATING RATES Though rare before World War I, floating rates did occasionally occur: in the New England colonies of Britain from 1711 to 1750; in Sweden from 1745 to 1777; in Russia on and off from 1768 and similarly in Austria from 1797; in France from 1789 to 1797; in Britain from 1797 to 1821; in the United States (with local exceptions) from 1814 to 1817, 1837 to 1842, 1857, and 1862 to 1878; in Spain from 1868; and in Latin American countries on and off from the nineteenth century. Floating rates became widespread in the early to mid-1920s and again in the 1930s. Canada was on a floating rate from 1950 to 1962, and the floating-rate system became a global norm in 1973. Many floating rates prior to World War II involved substantial depreciation due to irresponsible monetary policy (tremendous increases in the money supply).

EXCHANGE CONTROL Exchange control came into existence in the sixteenth century, in England and European countries. The controls in England in the sixteenth and seventeenth centuries varied in severity, and included licenses for foreign-exchange transactions, a tax on such transactions, and the forcing of private parties to sell their foreign exchange to the government at a disadvantaged rate. Controls were less common thereafter, until World War I. They were especially severe in the 1930s in Germany and some other European countries. Controls were retained by many countries for some time after World War II, were resorted to by the United States in the 1960s, and were used by some developing countries into the twenty-first century.

ACTIVE EXCHANGE-MARKET INTERVENTION Active exchange-market intervention involves an official institution initiating the buying (or selling) of foreign exchange with the intention of causing a currency depreciation (or appreciation) or preventing a currency appreciation (or depreciation). This policy, called a "managed float" (as distinct from a "free float," which is a float with no intervention) originated in England in the sixteenth century and was implemented again during the Swedish floating rate in the eighteenth century and briefly during the U.S. Civil War. Active intervention was rare until the last few decades before World War I, when several European countries and Japan adopted it under the gold standard to influence the exchange rate within the spread.

Many countries engaged in active intervention during World War I, and some countries did in the 1920s. In the 1930s, active intervention, led by Britain after it left the gold standard in 1931, came into its own. During the International Monetary Fund system, some countries used active intervention to set a narrower band than that prescribed. The norm exchange-rate system that came into general existence in 1973 was a managed float, with each country having full freedom of deciding the amount of intervention. Some countries, such as the United States, have verged from heavy intervention to no intervention and back again.

Even a "free" float involves central banks affecting exchange rates, because central banks heavily influence the money supply, which changes the money-supply/real-income ratio.

SEE ALSO Gold Standard; International Monetary Fund (IMF).


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Eagly, Robert V. The Swedish Bullionist Controversy. Philadelphia: American Philosophical Society, 1971.

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Morgan, E. Victor. A History of Money. Baltimore: Penguin Books, 1965.

Officer, Lawrence H. "The Floating Dollar in the Greenback Period: A Test of Theories of Exchange-Rate Determination." Journal of Economic History 41, No. 3 (September, 1981): 629–650.

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Lawrence H. Officer

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Rates of Exchange

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