There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.
1. Floating Exchange Rates
Unlike the fixed rate, a floating
exchange rate is determined by the private market through supply and
demand. A floating rate is often termed "self-correcting," as any
differences in supply and demand will automatically be corrected in the market.
Look at this simplified model: if demand for a currency is low, its value will
decrease, thus making imported goods more expensive and stimulating demand for local
goods and services. This in turn will generate more jobs, causing an
auto-correction in the market. A floating exchange rate is constantly changing.
In reality, no currency is wholly fixed or floating. In a fixed regime, market
pressures can also influence changes in the exchange rate. Sometimes, when a
local currency reflects its true value against its pegged currency, a
"black market" (which is more reflective of actual supply and demand)
may develop. A central bank will often then be forced to revalue or devalue the
official rate so that the rate is in line with the unofficial one, thereby
halting the activity of the black market.
In a floating regime, the central bank may also
intervene when it is necessary to ensure stability and to avoid inflation. However,
it is less often that the central bank of a floating regime will interfere.