In this discussion, "exchange rate" shall be defined as a qualitative value determined between two disparate objects, in this case currency. For example, the question "How many Swiss Francs is a dollar worth?" suggests the person is interested in trading a dollar (as a single unit of currency) for an equivalent value in Swiss francs.
If, for the purpose of this example, there has been an agreement made between the governments of Switzerland and the United States that effective immediately, one U.S. dollar would have a value exchange quotient of five Swiss Francs, then we would have established a fixed exchange rate and this would be expressed 1:5 (if the value was being measured in dollars) or 5:1 (if the value was being measured in francs). Fixed currency rates typically exist only in the realm of economic theory.
As Krugman points out, fixed rates impose the "necessity of coordinated monetary policies" (Krugman, 1995, 195). The philosophical theory behind fixed rates is that "By pursuing a tight monetary policy, any individual country can appreciate its currency and thereby achieve a rapid reduction in inflation" (Krugman, 1995, 195).
This rate differs from a fixed rate by allowing the values of individual currencies to rise or fall in relation to each other rather than to the arbitrary standards called for in a fixed rate system. The fluctuations in currency are caused by a phenomenon caused by the currency exchange rate. Simply defined, this means the value comparison of the American dollar in relation to other currencies of the world (Mariotti & Piscitello, 1995, 815).
For example, if $1 is converted into 100 Japanese yen, then the exchange rate is 1:100 D/Y. When the dollar buys more yen, it is said to be worth more and its value is said to "appreciate" while the Yen is said to "depreciate."
Turning again to Krugman, he points out that "Twenty years ago, advocates of floating rates argued that they...