Under a gold standard, a government fixes not the price at which people can buy and sell currencies, but the the price at which people can buy and sell gold. In our example, the Mexican government revalued the peso: its price or value went up from $.04 each to $.05 each.Īnother example of a fixed exchange rate system is the gold standard. When a government changes a fixed exchange rate, it is said to be devaluing or revaluing its currency, depending on whether the value of its currency goes down or up. People would no longer clamor at its doorstep trying to arbitrage the peso and the government would no longer be under pressure to print up more pesos.

If it ran out of pesos, it would have to print more in order to maintain the government guarantee.Īlternatively, were it to start to run out of pesos, the Mexican central bank could break its promise and change the rate at which it is fixing the peso to $.05/peso–the market rate. The upshot is that the Mexican central bank, because it is charging a rate lower than the market rate, would start accumulating dollars. That activity is an example of what is called arbitrage, which means that if there are two different prices for the same item, there is money that might be made by buying low and selling high so long as the transportation or transactions costs don’t eat up the difference. In fact, I could make a lot of money buying pesos from the Mexican central bank at $.04 each and selling them to people who couldn’t get there for $.05 each. Compared to the market rate, that would be a great deal! Certainly, if I wanted to buy pesos, I would buy from the Mexican central bank rather than the market.

central bank–would guarantee the new fixed exchange rate by guaranteeing that it will buy and sell pesos at $.04 each. The Mexican central bank–a government-run bank such as the Federal Reserve in the United States, which is the U.S. Government-set exchange rates are called fixed.įor example, the government of Mexico could fix its exchange rate by simply declaring that anyone who wants Mexican pesos can buy them for $.04 per peso, instead of $.05 per peso. Historically–up until the early 1970s–exchange rates were not flexible market rates, but instead were set by governments. Such exchange rates are called flexible or floating. dollars, so the exchange rate is $.05 per Mexican Peso.Ĭurrencies traded in markets–as they are presently for most countries–have prices that change by the minute, depending on whatever people will buy or sell them at. The exchange rate is usually quoted in terms of U.S. In our example, the exchange rate is either MXN20/$1 or $.05/MXN1. Thus, for each pair of currencies, there are two ways to describe the exchange rate.

Or, for each Mexican Peso, you can receive $.05. dollar for 20 MXN (Mexican Pesos) that means you can receive 20 MXN for each U.S.

The price at which you trade one currency for another is called the exchange rate. Markets in which you can trade one kind of money for another are called currency markets or foreign exchange markets. All you have to do is find someone with whom to trade. Just as you can trade the goods you own–that is, you can trade corn for rice or high-tech steel knives or computers–you can trade one kind of money for another. In most cases, it’s easy to trade one currency for another. Colombia has money called the Colombian Peso. Germany has money called the Deutsche Mark. For example, the United States has money called the U.S. Usually a country’s money, also referred to as its currency, is called by its own unique name.

Exchange rates currency