Flexible Exchange Rate Systems

Most countries allow their currencies to fluctuate in value relative to foreign currencies. The currency values will fluctuate with changes in demand and supply, similar to demand and supply fluctuations in the market for products. An increase in the demand for housing will increase the value (price) of houses. Similarly, an increase in the demand for the Australian dollar will increase the value (price) of the Australian dollar.

Depreciation and Appreciation

Depreciation and appreciation are changes in the values of currencies within a flexible exchange rate system.

If the supply of dollars increases, or the demand for foreign currencies increases relative to the demand for the dollar, then the value of the dollar falls. We say that the dollar depreciates.

If the demand for dollars worldwide increases, then the value of the dollar rises. We say that the dollar appreciates.

Example 1

Before U.S. dollar depreciation:
\$1 = 100 yen

After U.S. dollar depreciation:
\$1 = 95 yen

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Fixed Exchange Rate System

Some countries prefer to keep their currency values fixed relative to other foreign currencies. For example, if 100 units of a foreign currency exchange for \$1, and the two countries decide to keep their currency values fixed for a period of time, we speak of a fixed, or pegged, exchange rate system. Through most of the 1990s China kept its currency fixed relative to most foreign currencies. Today China lets its currency fluctuate, even though the Chinese government still influences the rate at which it lets its currency fluctuate. No major industrial countries use a fixed exchange rate anymore in today’s world economy.

Devaluation and Revaluation

In a fixed exchange system, if after a certain period of time, the government decides to “fix” its currency at a higher or lower value, then we speak of revaluation or devaluation respectively.

 Example 2 Before devaluation: \$1 = 2 PHP (Philippine Peso) After devaluation: \$1 = 1.5 PHP