EXCHANGE RATE

The price of one country's currency described in terms of another country's currency is known as the foreign exchange rate. The rate is a mechanism used to convert the value of one country's currency into the currency of another. The rate is expressed in terms of the currencies of both countries such as dollars per pound, francs per dollar, or yen per franc. A U.S. citizen who buys a product from France would pay in dollars, but the French would want francs. The dollars are converted into francs at the current exchange rate. If the exchange rate is one dollar per five francs, the U.S. citizen would pay nine dollars for a French product that costs 45 francs.

The kind of exchange rate system countries choose to operate under determines exchange rates. Historically three choices have been available: a fixed rate, a flexible or floating rate, and a managed flexible or managed floating rate. A fixed or pegged exchange rate is a system where governments of different nations agree to a set ("par") value for their currencies. The price of one currency is fixed in terms of another so the rate does not change. Before 1914 all countries had fixed systems defining their currency in terms of a given amount of gold. If one ounce of gold were worth $20, but four British pounds, then the exchange rate would be $20 per four pounds, or five dollars to one pound. In a flexible rate system the market sets the value of currencies based on supply and demand. Under a managed floating rate countries are on a floating rate system, but if the exchange rate for their currencies rises or falls too far, the central banks intervene or manage the rate.

Difficulties with the fixed gold standard led to the Bretton Woods System immediately after World War II (1939–1945). Under this system countries maintained a fixed exchange rate with each other but based their currencies on the U.S. dollar which was fixed at $35 per ounce of gold. All nations could trade their currencies for dollars and then buy gold at a rate of $35 per ounce from the United States. The Bretton Woods agreement also created the International Monetary Fund, an international economic "police" organization. By 1971 President Richard Nixon (1969–1974) announced the United States would no longer redeem dollars for gold and since then the world has been on a managed floating exchange rate system.