Pegging of the currency

When the value of domestic currency is tied to the value of another currency, it is called 'pegging'. Under the fixed exchange rate system, a currency is pegged to a reserve currency or to a basket of 'key' currencies. Besides, currencies are pegged also to the Special Drawings Rights (SDRs), an instrument created by the IMF. The currencies of about one third of the developing nations are pegged to a single currency, that is, either to the US dollar or to French franc. The value of a pegged currency is allowed to vary within a certain lower and upper limit.

How is the forex rate determined?

There is no simple answer to this question. it depends on whether forex market is free or controlled, and whether the government adopts fixed or flexible exchange rate policy. The economists have attempted to explain the exchange rate determination resulting in different kinds of theories the market theory, the purchasing power parity theory, the monetary theory and the portfolio- balance theory. In this section, we will discuss only the first two theories which are in currency - first the market theory of exchange rate determination and then the purchasing power parity theory.