(ORDO NEWS) — Currency exchange rates can seem unpredictable. But you must understand what they are formed from in order to buy and sell foreign currency at a favorable rate.
Today, most currencies have managed floating exchange rates, but this has not always been the case. This is what makes up the value of any currency.
Exchange rates can be either fixed or floating. Fixed exchange rates use a standard such as gold or another precious metal, and each unit of currency corresponds to a fixed amount of that standard that should (theoretically) exist.
For example, in 1968 the US Treasury determined that it would buy and sell one ounce of gold at $35. Other countries set their own value for an equivalent amount of this asset.
A floating exchange rate means that each currency is not necessarily backed by a physical resource. Current international exchange rates are determined by the managed floating exchange rate.
A managed floating exchange rate means that the value of each currency depends on the economic actions of its government or central bank.
A managed floating exchange rate has not always been used. The gold standard determined international exchange rates until the 1910s.
Another very similar system, called the gold exchange standard, became prominent in the 1930s. This system allowed countries to back their currencies not with gold, but with other gold standard currencies such as US dollars and British pounds.
The International Monetary Fund (IMF) was responsible for stabilizing currencies until the 1970s, when the US stopped using fixed exchange rates.
What factors affect exchange rates
Governments can stabilize their exchange rates by importing fewer goods and exporting more. Similarly, they can devalue other currencies to boost the status of their own by selling them to other countries.
The gold standard exchange and the IMF added stability to the world market, but it was not without problems.
Tying a currency to the final material would make markets inflexible and could potentially result in one country being able to economically isolate itself from trade. A managed floating exchange rate, on the other hand, encourages trade.
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