Define each of the following terms:
Exchange rate: The exchange rate is a rate at which certain units of currency of a country, can be purchased with one unit of currency of another country. It is the value of one currency for the purpose of conversion to some value of another foreign currency.
Fixed exchange rate system: Fixed exchange rate system is a system where the central bank of the country uses an open market mechanism and is responsible to buy or sell the country’s currency at a fixed price, in order to maintain its pegged ratio. When a country attaches their currency with some security like gold or the currency of another country like the Dollar, it is called pegging. Pegged ratio or rate can be determined by value of one ounce of gold per unit of currency, or any other relevant measure which the central bank deems fit. Thus, this can stabilize the value of its currency in relation to the reference security, to which it is pegged.
Floating exchange rate: Floating exchange rate is that rate of exchange which is determined by two countries based on the relative demand and supply forces for their currencies. The international trade and investment activities play a vital role in determining this exchange rate. Total bilateral trade activity i.e total volume of exports and imports is an important factor to arrive at this rate. When there is a situation of excess imports than exports, it is called a situation of fiscal deficit, which leads to depreciation in the value of home currency and vice versa. Sometimes, there is an intervention of the government to regulate the currency.
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