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An overview of important concepts and theories in relation to foreign exchange (forex) rates

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  1. Introduction
  2. Meaning of exchange rate
  3. Important terms
    1. Fixed exchange rate system
    2. Intervention
    3. Flexible exchange rate system
    4. Devaluation
    5. Depreciation
    6. Fixed rate to flexible exchange rate system
    7. Gold bullion
    8. The gold standard
    9. Floating rate system
  4. Bretton Woods system
  5. Exchange rate systems in different countries
  6. Models and theories of exchange rate
    1. Purchasing power parity theory (PPP)
    2. The Mundell Fleming model: Perfect capital mobility
    3. Dornbusch theory on monetary expansion: Short and long term effects
  7. Foreign exchange rate forecasting
  8. Techniques of forecasting exchange rate
  9. Conclusion

The rate of exchange means the price of one currency in terms of another currency. Different countries have adopted different exchange rate systems at different times like the Gold Bullion, Gold Standard and the Bretton Woods system. The last system was soon replaced by the Floating Rate System.

Countries of the world have been exchanging goods and services amongst themselves from the time immemorial. With the invention of money, the rigors and problems of barter trade has given way to exchange of goods and services for currencies instead of exchange for goods and services. As every sovereign nation has a distinct national currency, international trade has necessitated exchange of currencies and this exchange of currencies necessitated exchange rate. Like any other commodity, the price of one unit of foreign currency can be stated in terms of domestic company.

[...] In 1944, following world war II , the United States and most of its allies ratified the Bretton Woods Agreement which set up an adjustable parity exchange rate system under which exchange rates were fixed (pegged) within narrow intervention limits (Pegs) by the United States and foreign central banks buying and selling foreign currencies. This agreement fostered by a new spirit of international cooperation, was in response to the financial chaos that had reigned before and after the war. In addition to setting up fixed exchange parities (par values) of currencies in relationship to gold, the agreement established the International Monetary Fund to act as the ?custodian? of the system. [...]

[...] Allowing exchange rates to float in the midst of financial chaos was like setting a boat adrift in the middle of a storm?smooth sailing was next to impossible. To make matters worse, the tripling of oil prices by the Organization of Petroleum Exporting Countries (OPEC) during the 1973 hit the foreign exchange market like a hurricane, causing global inflation to rise with the tide. However, the circumstances under which floating rates were introduced are by no means the only problem with the system. [...]

[...] For example, in case of inflation rate, we know that inflation rates affect future exchange rates. Future exchange rates can be forecasted by forecasting inflation rate. The statistical models work b establishing a relationship between future exchange rates and the variables that affect future exchange rates. Usually, as it involves more than two variables, a multiple regression analysis based on statistical models is done. In any forecasting model, the future exchange rate is a dependent variable as it depends on various economic indicators. [...]

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