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Foreign Exchange: The Complete Deal by James Sharpe

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4. The Theory of Foreign Exchange: How Exchange Rates are Determined

The exchange rate is the price at which one currency is convertible into another, for example an exchange rate of 1.7000 for GBP/USD means £1 will buy $1.70. Exchange rates relate prices and costs in one economy to those in other economies.

The rate can be set in various ways. It may be fixed by the government, laid out in an international treaty, or it could be linked to something external, for example gold. However, most exchange rates are defined by a floating exchange rate system, as discussed in chapter 1. Thus the following chapter applies to a floating exchange rate system.

Exchange rates and supply and demand

In a floating exchange rate system, the price of a ...

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