You are on page 1of 11

FOREIGN EXCHANGE RATE SYSTEMS

:

There are different kinds of fixed exchange rate regimes. Similarly to prevent the exchange rate depreciating. The increased supply of domestic currency lowers its value.FIXED EXCHANGE RATE SYSTEM: A fixed exchange rate system is an exchange rate regime in which the government of a country is committed to maintaining a fixed exchange rate for its domestic currency. In this system government of a country announces an exchange rate called parity rate and defends it. the necessary monetary authority of a country may announce the par value. In order to make such transactions government must have sufficient quantities of foreign and domestic currency. To prevent the exchange rate from appreciating the government buys foreign currency in exchange for domestic currency. Under one such regime. . as well as a band of exchange rates within which the exchange rates may vary. government buys domestic currency using the foreign currency.

governments may bypass those rules for short term gains Exchange rates determined at the discretion of the monetary authorities cause uncertainty in the future exchange rates.Advantages: It ensures stability and certainty in exchange rates It creates confidence in the currency. The system is inflexible and therefore leads to slow growth of international trade . which promotes international trade and investments It facilitates domestic economic stabilization Deficiencies of fixed exchange rate: The exchange rates are determined by the monetary authorities without taking into consideration the demand for and supply of the currency The exchange rates are determined by governments on the basis of certain extraneous (irrelevant) considerations. leading to trade wars in the international market Although each fixed exchange rate has certain rule.

In this system the domestic currency is anchored to a foreign currency which is also known as reserve currency. If is functions along with central bank the central bank virtually losses its monetary authority. The value and stability of local currency is directly linked to the value and stability of the anchor currency. The board selects a foreign currency which is strong and this currency is internationally traded as anchor currency. A currency board will function alone or work in parallel to central bank of the country. There are no restrictions on individuals and businesses exchanging the locally issued currency with the anchor currency at a fixed rate on both current and capital account.Currency boards: A currency board is a country’s monetary authority that issues its base money (notes and coins) and fixes the exchange rate. A currency board is fully committed to complete convertibility of local currency into the anchor currency. . In this system it is possible to fix the exchange rate in terms of a basket of currencies rather than one currency the currency board may rigidly fix the exchange rate in terms of a single currency.

A central bank will work in place of it but with specific rules dictating the level of the reserves it should maintain. The traditional currency board system had its roots in English bank act in 1844. The major problem is loss of independence. That is a country under currency board regime can issue domestic currency only when it has foreign exchange reserves to back it. The main advantage is that it offers the prospect of a stable exchange rate.To honor its commitment a country under the currency board regime holds reserves of foreign currency (or gold or some other liquid asset) equal at a fixed rate to at least 100% of domestic currency issued. The currency board system no longer exists in its pure form today. . It generates fiscal discipline by preventing governments from direct monetary financing of government expenditure. Dollarization: The system of adopting the currency of another nation as the legal tender is known as dollarization. Some nations abandon their domestic currency and use one of the reserve currencies.

it may become adjunct to the country issuing the currency. So a country might peg its currency to a basket of currencies. When currencies are not equally important weights should be assigned to each currency in accordance with the economic power of nations included in the basket. The largest currency union in world has been formed by 12 countries of European union using euro as common currency. A basket of currencies is likely to be less variable than a single currency.This happens when a country is unable to manage its own economic affairs. Currency Unions: When a group of countries feel that multiple currencies and exchange rate fluctuations are seriously affecting their trade. In such regime countries decide to adopt a common currency so that exchange rates between the member countries of the union disappear. Currency baskets: Pegging a currency to another single currency might be risky at times. . If currencies for a basket are chosen correctly the resulting peg will be more stable. they may adopt an exchange rate regime known as currency union.

FLEXIBLE EXCHANGE RATE SYSTEMS: Under flexible exchange rate system the exchange rate is determined by the forces of demand and supply for a currency through another currency. Advantages: In long run it keeps BOP of all countries in equilibrium through and adjustment mechanism If a country is able to control trade deficit it implies that it has a strong economic system A country can boost its image and attract foreign investments by adopting flexible exchange rate system There is no need to bother about tariffs. quotas etc as they are automatically taken care by market forces and by the exchange rates The system reflects true cost price relationship between two countries It allows countries to pursue their own economic policies and maintain their economic sovereignty . subsidies.

There is no intervention by the monetary authority of a country in exchange rate determination when the domestic currency is freely floated against the foreign currency in foreign exchange market. Exchange rates vary in accordance with changes in demand and supply of a currency. The free float is also known as pure or clean float. Demand and supply depends on several factors which includes economic. social. This is because there is no compulsion that a country should keep their money supply and inflation under control Free float: In a free float the government does not announce a parity rate. political and technological factors. . The market participants respond to new information instantaneously.Limitations: It cannot ensure stability in exchange rates which results in uncertainty and speculation It may encourage speculation in foreign exchange market and cause violent fluctuations in exchange rates Countries under this system may also witness a high rate of inflation.

A currency can be pegged to another currency. .Managed float: In this system the government intervenes in the foreign exchange market whenever it wants the exchange rate to move in a particular direction or to stabilize at a target level. to a basket of currencies or to SDRs. When a government does not make an upward or downward change in its exchange rate when such a change is warranted it also amounts to a managed float. CURRENCY PEGGING: It involves fixing the value of currency in relation to the value of another currency. It is also known as managed or dirty float. It is primarily aimed to eliminate excess volatility and reducing uncertainty. A country may peg its currency to the currency of its major trading partner in order to stabilize its trade receipts and payments. This is because a managed float is not only for smoothing out daily fluctuations but also for moderating or preventing short term or medium fluctuations. A country with a pegged exchange rate establishes a fixed exchange rate with another currency or a basket of currencies.

BRITISH POUND AND US $ at present. Soft pegging involves frequent adjustment of exchange rates. A currency may also pegged to a basket of currencies. Pegging may avoid risk of taking a wrong decision with regard to devaluation or revaluation of the currency. JAPANESE YEN. This may be high frequency pegging (day to day or week to week pegging) or low frequency pegging (month to month or quarter to quarter pegging). The pegging of currency may take a form of hard pegging. . which will give more stability to the exchange rate.If a particular country’s currency is not pegged any change in the value of the currency of the country with which it has major trade relations will adversely affect the cash flows of the country. which itself is pegged to a basket of four currencies . In hard pegging exchange rates are fixed and the government has no plans to change them. Currency boards are examples of hard pegging.EURO. A currency may also pegged to SDR. The adjustable pegging system allows the government to revise or adjust exchange rates periodically example Bretton Woods system. adjustable pegging or soft pegging.

A crawling peg may take the form of a crawling broad band or a crawling narrow band. If actual exchange rate approaches a certain limit. The exchange rates are fixed but considerable fluctuation is permitted around the central parity rate. .Crawling peg: It is a hybrid system with some features of the flexible exchange rate system and some features of fixed exchange rate system. It provides more flexibility and is closer to a floating system in terms of its merits and shortcoming.20%) to provide more flexibility. it involves fixing a par value of currency and allowing the exchange rate to move within in a given percentage. In crawling broad band the limits around the central parity are wide enough (say +/. The crawling narrow band is almost equivalent to the fixed exchange rate regime. the central bank intervenes by buying or selling home currency for the required foreign currency.