It was only a few decades ago that currencies around the world were back by gold which meant that whatever piece of money that people used in their day-to-day lives represented a real amount of gold held by that government. Today, the main influencing factors on exchange rates are as illustrated in the infographic below.
The edited excerpts above and the infographic* below originally come from hiwayfx.com as posted under the title What influences exchange rates?.
Since the Jamaica Accord of 1976, which ratified the end of the Bretton Woods System, the gold standard system has been permanently abandoned and the world now adopts a floating foreign exchange rate. Although the name might suggest exchange rates are left to their own devices – today, most governments use one of the following methods:
- Managed floating rate
- The exchange rate is allowed to float in the foreign exchange market, with supply and demand determining the value of a given currency.
- The value is ‘managed’ – the central bank sets the range its currency is allowed to freely float between, and intervenes when necessary to manipulate the value by buying and selling currencies.
- The benefit of this is that governments can minimise any risks of extreme currency fluctuation, which is highly possible in a free-floating system.
- Pegged rate
- A country fixes its exchange rate to that of another country’s currency.
- To keep the rate stable, the country that is pegging its currency must keep large reserves of the foreign currency on hand to mitigate any potential shifts in supply or demand.
- Countries with unstable economies usually use a pegged rate system.
- The downfall of this system is that the market value of a currency isn’t always truly reflected in the pegged rate – thus possibly encouraging a black market.
- Dollarization, or currency substitution, is when citizens of a country either officially or unofficially use another country’s currency as legal tender.
- The benefit is often that the foreign currency is more stable than the domestic currency.
- Examples of countries who use dollarization include El Salvador, Ecuador and Panama, who officially use US dollars. Other examples include Namibia, Swaziland and Zimbabwe who all use the South African rand alongside the Namibian dollar, Swazi Lilangeni and US dollar/Euro/Botswana pula respectively.