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The exchange rate in a free market is the result of the interaction of demand and supply. Demand for a particular currency is, from tangible view point, the export of the country, because people want to buy English exports need pounds to do so. On the other hand the supply for pounds is determined by the amount that England imports as the England importers need to change their pounds to other currencies to do so. Where the two intersect the equilibrium is formed:
In the current example the equilibrium occurs at a rate of 1.60 where q units (e.g. pounds) are demanded and q units are supplied.
The same type of analysis applies to every currency. The demand for sterling is also the supply of dollars if the pounds are exchanged to dollars etc.
This is a very simplified view of real life, because only demand for tangible reasons is included (trade, tourism etc.) In actual life the changing of currencies because of these reasons only account for 5% of the total volume of the trade. The currencies against which the rate is measured can change too. That is why a system of trade weighted indices was set up to take account of all the changes.
The other 95% comes partly from the different interest rates in different countries and from the speculation with currencies. If interest rates are high, people want to hold their money in the banks in this country. That increases demand for that particular currency. Look at diagram over the page:
As seen in the diagram, the new equilibrium is reached at E1 and the exchange rate has risen. Sometimes the changes are more complex, because the supply of pounds can contract at the same time, because people want to hold their money in the home country (high interest rates). That will increase the exchange rate even further.
Rising or lowering the exchange rates is widely used by governments world-wide to maintain the exchange rate within a desired range. A government can do that by buying or selling its fixed interest rate securities. If it sells them, the price will fall and so the relative interest rate will rise and vice-versa.
The government can also just set its rate (usually the rate by which it is prepared to lend to LDMA as a last resort) as the commercial banks in the UK will set the same interest rate as the Bank.
Other rate determining reasons are the inflation differences, differences in invisible trade, capital movements between countries, speculation with currencies, government activities (supporting the pound by buying it up) and the confidence in the future (the anticipation of future exchange rates). They all have similar effects on demand as interest rates do.
Floating exchange rates were only first introduced in the 1970s.
When the exchange rate is not allowed to move freely based on demand and supply, that is called fixed exchange rates. A government can base the exchange rate on the gold standard (largely abandoned nowadays) or it can peg its currency (fix the exchange rate to another currency, e.g. 1DEM=8 Estonian crowns). The peg is called an adjustable peg, if the rate is fixed, but if it can vary a bit.
Another method of stabilising the rate is by exchange controls. This means putting restrictions on changing currencies into effect (used by USSR for many years in the past).
Both floating and fixed exchange rates have numerous advantages and disadvantages.
The advantages of floating rates include automatic stabilisation of the exchange rate. It has been argued that the fixed rate system could not have coped with the huge fluctuations of the 1970s.
A Fixed exchange rate places constraints upon internal policies that floating exchange rate does not. For example, a country with balance of payments problems, if it has adopted a fixed exchange rate policy, can only cure its economy by deflating it, which causes unemployment, whereas floating exchange rates will "cure" the problems automatically in the short run, by lowering the rate. This again has several problems the from moral point of view, because every country wants to (in non-economic terms) keep its currency "strong", or more economically, to boost it's exports.
The presence of crisis that occur when a fixed rate system is badly managed will be eliminated with the floating rate system. These crises happen specially when pressure is put on a currency to devaluate or revaluate it and a government has to "fight" with it.
Floating rates offer greater flexibility of trade, especially after the oil price have changed and extraction of the North Sea oil has been started.
Floating rates also avoid the "import" of inflation as the rate will change accordingly, whereas with fixed rates the country would face inflation because of the rising import prices.
High reserves are needed with fixed exchange rates to support the rate. Governments usually buy up the excess supply or sell to the excess demand or just restrict the amount a person can change.
Big reserves are also required if a government wishes to maintain the rate , although, because of the relative inelastic supply / demand, not as much as might be predicted:
In this example the fixed rate is taken to be 120 (price floor) and equilibrium is E. When demand decreases to DD1. The government buys up the excess E1A to maintain the rate. The reverse applies when the demand falls to DD2 then the government has to sell E2B to maintain the rate. The Exchange Equalisation Account was set up for this purpose in 1932 and is controlled by the Bank. Nearly all governments operate a similar system and it is called a "dirty float" system. The Equalisation Account has lost great sums of money in 1970s by defending an unrealistic exchange rate. So management of the currency can still exist even in the floating exchange rate system.
There are also some disadvantages with the floating exchange rate.
The main one is the uncertainty involved in the future. Firms and banks have overcome this by setting up a forward system. That means contracts with promises to change a certain amount of money with a certain exchange rate after a certain period.
Lack of investment is also associated with a floating exchange rate as firms can not be sure about their future profits.
Large scale speculation will also take place if the exchange rate changes as it has been a quick way to make profits. Also, if interest rates are changed, the "hot money" will be moved to that country. This distorts the balance of trade.
A country with a fixed exchange rate seems to have greater discipline in its economy.
Many organisations were set up to reduce the floating of the currencies. These include the European Monetary System, the International Monetary fund and some others. The Plaza agreement and the Louvre accord attempted to limit the fluctuations in G5 and G7 countries respectively.
Although the greater insurance that the fixed exchange rates give to international trade and investors, it is argued that it is too expensive to maintain and floating exchange rates have generally been adopted with governments intervening often to diminish the fluctuations.