Exchange Rates:

An exchange rate is the current market price for which one currency can be exchanged for another. In other words it is the price of one country's money in relation to another's. Exchange rates are divided into fixed exchange rates and flexible exchange rates. An exchange rate is fixed when two countries agree to maintain a fixed rate through the use of monetary policy. Historically, the most famous fixed exchange-rate system was the gold standard; in the late 1850s, one ounce of gold was defined as being worth 20 U.S dollars and 4 pounds sterling, resulting in an exchange rate of 5 dollars per pound. An exchange rate can be a flexible exchange rate or a floating when two countries agree to let international market forces determine the rate through supply and demand. The rate will fluctuate with a country's exports and imports. Most world trade currently takes place with flexible exchange rates that fluctuate within relatively fixed limits. The basic theories underlying the exchange rates include:

• Law of One Price: In competitive markets free of transportation costs barriers to trade, identical products sold in different countries must sell at the same price when the prices are expressed in terms of their same currency.
• Purchasing power parity: As inflation forces prices higher in one country but not another country, the exchange rate will change to reflect the change in relative purchasing power of the two currencies.
• Interest rate effects: If capital is allowed to flow freely, the exchange rates stabilize at a point where equality of interest is established.

All exchange rates are susceptible to political instability and anticipations about the new ruling party. Confidence in a currency is the greatest determinant of the exchange rates. Decisions are made keeping in mind the future developments that may affect the currency. And any adverse sentiments have a contagion effect.