Running head: MONETARY THEORY

Monetary Theory
Name
Institution Affiliation

MONETARY THEORY
Introduction
Exchange rate systems are one of the ways that a state or country manages its
currency with respect to foreign exchange market and foreign market. This is a method
employed by respective governments to administer their respective currency in comparison
with other major currencies in the world. The exchange rate system and domestic foreign
exchange market are directly linked to monetary policies. The two main exchange Systems
are float, fixed exchange rates, and between these two combinations of exchange rates are
other vital exchange Systems (Obstfeld, Shambaugh & Taylor, 2005). The other exchange
rates are floating or partly fixed.
For the case of floating exchange rate system, the values of the currencies are
determined by the flow of the financial market. The most used rates in the world are floating
rates. The other names of floating rate Systems in literature are managed float or dirty float.
The reason why they bear the above name is that governments always intervenes the foreign
market to curb excessive instability in foreign exchange rates. The study describes various
types of exchange rate systems as well as their pros and cons.
Free float and managed float system
Managed and free exchange rates System is where exchange rates oscillate, but the
central banks are mandated to control the exchange rates by selling and buying currencies.
Free float and managed float system, also known as dirty floats are whereby exchange rates
alter day in day out. At this point, all the currencies are managed because the government or
the central bank intervenes to effect the value of their currency. Hence, when a country
claims to have a floating currency then it must occur as a managed float.

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How a Managed Float Exchange Rate Works
Generally, the central bank sets a range, which its currency value may float freely
between other major currencies. If the countrys currency goes beyond or below the ranges
ceiling, the government or the central bank controls to manage the currency value back
within the required range. The management undertaken by the central bank takes two
different forms that include selling or buying large amount of its currency to offer price
resistance and support (Hill & Jain, 2007). For example, if the value of the currency is above
its range, the government via the central bank ought to sell its currency that it has in the
reserves. By placing more of its currency into circulation, the government decreases the
currencys value.
Advantages of Free Float and Managed exchange Rate
The free float and managed exchange rate permits the exchange rate to alter or
fluctuate constantly with no official boundaries. However, authorities, via direct intervention
in the foreign exchange market, manage the unofficial boundaries. This is evident for states or
countries with weak economies, because there are sure that the government will take charge
in order to control the countrys currency.

The other most significant advantages of this system concerns with the market forces.
This means that there is a competent usage of financial resources to determine the exchange
rate. Hence less opportunities for speculators to make profits at the expense of the
government or central bank.
Moreover, the exchange rate system over monetary independence, because the
domestic currency will be in equilibrium against the foreign currency, thus, the economy of
the respective country cannot accommodate the foreign and domestic shock such as interest
rates and changes in terms of trade.

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The managed float and free float system provides limited exchange rate variability,
removing the fear of huge devaluations in the future (Hill & Jain, 2007). In addition, other
organizations such as banks, private firms, and the government are aware of the risks that
emerge for offering liabilities dominated in foreign currency. In such a case, an inflationary
shock is a state or country cannot be transferred to other countries or states since the shock is
captivated by the flexibility.
Disadvantages of Free Float and Managed exchange Rate

On the other hand, there are various arguments against the managed floating
currency; high exchange rate variability causes uncertainty, which often discourages
international investment and trade (Arestis & Demetriades, 1997). This prompts deployment
of intervention policy and interest rates to affect its behavior. In addition, using such system
poses risks to traders who cannot be hedged at moderate cost; and self-generated movements
in the exchange rate that exaggerate disequilibrium rather than promote ideal changes or
adjustments.
Furthermore, the future way of free float and managed exchange rate is unknown,
thus creates problems or hurdles in pricing strategies and business planning.
Fixed Exchange Rate System
This is an exchange rate system whereby the currency value is fixed against
another major single currency, or to another degree of value such a diamond or gold. The
fixed exchange rate is used to stabilize the value of a weakening currency against the
currency that is secured to. This makes investment and trade between the two-bullied
currency more profitable and easier, and is usually used for small economies that external
trade encompasses large section of their Gross Domestic product. In addition, the
exchange rate controls inflation. However, as the reference value falls and rises, so does

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the fixed currency. According to Fleming model, an existence of perfect capital mobility
triggers the fixed exchange rate to prevent the government from using domestic monetary
policy to gain macro-economic stability.
In such kind of system, the government determine or controls the worth of its
currency with respect to a fixed weight of gold or a fixed among of another states or
countries currencies. For example, the central bank for a country remains committed to
sell and buy its own currency at a fixed price. The banks mandate is to offer the foreign
currency needed to finance imbalance of payments. In a fixed exchange rate system, the
exchange is held to alter in a narrow or small margin. Thus, monetary organizations
intervene in the foreign market by buying and selling nations currency to maintain the
exchange rate firmness.
There are two main advantages of fixed exchange rate System. First, a long-term
fixed rate develops a stable basis for pricing and planning, therefore vital in developing
international trade and investment as well as exclusion of exchange risks. The second
advantage is that fixed exchange rate represents an outstanding nominal platform for
monetary policy; therefore, many nations faced with macro-economic stability adopt this
system. In addition, the system also helps in imposing direct castigation on monetary
policy (such a currency board) preferred in situations where financial markets and
instruments are insufficiently developed for the operation of a market related monetary.
Moreover, economies or counties that opt for fixed exchange rate always
experience currency substitution, and when such countries are faced with financial shocks,

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they always revert to fixed rate exchange system because it automatically reduces
monetary volatility.
Disadvantages of Fixed Exchange Rate System.
On the other hand, this system is criticized due to the increased number of
disadvantages it poses to the economy. The first is that, under this System, increase in the
foreign interest rates leads to lower levels of output and increases the domestic interest rates,
thereby attributing to costly affair for monetary authorities to maintain financial purity.
Furthermore, it exposes domestic firms to unwarranted competition from imports and their
exports become increasingly less competitive.
Secondly, under this system of exchange rate, a nation is denied its monetary
independence. It calls a country to come up or develop a policy of monetary contraction and
expansion to maintain a stable rate of exchange.
Thirdly, fixed exchange rate System does not truly reflect cost-price affiliation
countries currencies. Rarely do two states or nations share the same economic policies.
Thus, the cost-price association between them keeps changing. For this to be possible, then
the exchange rate should be flexible. This means that the system does not reflect cost-price
relationship.
Pegged Exchange Rate System
A pegged exchange rate system is a mixture of floating and fixed exchange rate systems.
Generally, a state will peg its currency to one of the major currencies such as United States
Dollar or European Pounds, or a basket of other currencies. The ultimate choice of the
currency of the basket if affected by other currencies in which the country international debt
is dominant to an dimension in which the state trade is concentrated with a certain trading

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partners. In the case of pegging a single currency, the currency is made stronger if the peg is
not related to a certain principle-trading partner. If the countries debt is dominated with other
currencies, the choice begging the currency becomes a problem. However, with a pegged
exchange rate, the first target exchange rate is determined, the actual exchange rate set, and
the real exchange rate can be allowed to alter or fluctuate in a platform or range around the
first target expected. In addition, given the economic challenges, the targeted exchange rate
may also be modified.
This type of exchange rate is used by countries with small economies. To protect a
certain rate they ought to relay to the central bank for intervention purposes; the central bank
using various methods such as imposing of quotas or tariffs, or even to formulation of
restrictions on the capital flow of currency. It is worthy to mentioning that when the pegged
exchange rate is far from the actual market rate, it will be a costly affair to defend it and the
solution cannot be long-term. In such a situation currency speculators benefit.
Advantages of Pegged Exchange Rate System
The first merit of the system is that is helps in reduction of uncertainty in
international portfolio and trade flows. It has been noted around the world that exchange rate
risks are considered barriers to international business. However, under this system, guessing
of the next exchange rate period using scare resources is not evident hence a solution to
international business.
Secondly, the system creates an automatic balance of payment adjustment
mechanisms to maintain external and internal balance of payments. Such kind of mechanism
is called price-specific flow mechanism. It takes care of imbalance of payments between
countries price levels and current accounts. For example, if a country accumulates specie

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and runs a currency surplus account, the prices increases, making the nation or country a
prone place for foreign investments. Such a situation is helpful since it reduces foreign
deficits as well as current account surplus in the home countries.
Thirdly, the exchange rate system in itself is an asymmetrical adjustment of monetary
policies under a reasonable gold standard. If a countrys central bank increases its money
supply, it lowers the pressure of the states interest rates. Such a situation makes other
nations or countries more appealing to investors (Arestis & Demetriades, 1997).
However, pegged exchange rates have demerits as well. Before looking at these
disadvantages, it is also worthy questioning some of the advantages for better understanding.
Disadvantages of pegged Exchange Rate System
The system has questionable price stability mechanisms. A metallic standard is
known to promote price stability. However, various studies show that gold standard errors
are known to experience huge fluctuations in the average price levels in a given country.
Such fluctuations are caused by changes in the price of gold with respect to the price of other
services and goods.
Pegged exchange rate systems have doubtful prosperity and stability. Since price,
stability causes economic stability and finally prosperity, the assumption is that the metallic
standards are linked with lower and higher volatility in growth. One of the most disastrous
economic downfall in recent years, the Great Depression, was cause under the pegged
exchange rate System. In addition, complex and contradictory monetary standards and
policies were adopted during the gold standard period in the 18th century, which led to higher
unemployment and lower economic growth among countries.
Under the pegged exchange rate system, the price-specie-flow mechanism is

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questionable. The mechanism did not work under the gold standard period. Generally, the
system does not work in a reserve currency standard country. It can be depicted that the
mechanism cannot work and if it did work then all countries, current accounts would be
balanced. This is a clear indication that the pegged exchange rate system has various
downfalls to be considered valid or reliable (Arestis & Demetriades, 1997).
Crawling Pegged Exchange Rate Systems
The System is an amalgamation of pegged and fixed exchange rate systems because
the currency is tied against another major currency, but alternates within a limited margin.
One of the well-known crawling exchange rate arrangements created or developed among the
European states in 1973, whereby their currencies they come up with dimensions to maintain
their currencies within a specified limit of each other (Buiter & Grafe, 2012).
Advantages of Crawling Pegged Exchange Rate System
The key merit of this systems is that it offers committed and credible monetary policy hence
provides monetary discipline that cats as a nominal anchor for disinflation. This is cause from
the fact that under the pegged System, the government or the country has scare ability to
exercise short-term optional monetary policies, because crawling pegged rates manage the
international flow of local or domestic monetary supply.
The other advantage is that crawling pegged rates are preferred when there are
existing shocks linked with unstable domestic financial and monetary policies. Moreover, if
a local currency is pegged against a major or more stable currency, such as the Dollar or
Euro. The fluctuations are more predictable hence causing more trade opportunities to
potential investors. The rate of the crawl is always set lower than the forecasted inflation, to
fight any challenges associated with inflation in the future.

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Disadvantages of Crawling Pegged Exchange Rate System

However, this system has various disadvantages. First, when a country is faced with
high inflation rates, it currency is pegged against other currencies causing loss of
competitiveness and overvalued currency. In addition, the system also creates misalignments
controls on international financial flows and trade as well as faces speculative attacks, which
breaks down cost of currency crisis.
The other disadvantage is that the government cannot capital flows from speculative
movements, the rate under the crawling System responds to movements as well as creates
instability. This leads to high control of international and domestic trade activities that are
very costly. Thirdly, crawling pegged system creates financial inflexibility when fighting
inflation. Generally, crawling pegged system provides short-term shield against unexpected.
Target Zone Exchange Rate System
This a system whereby two countries agree to keep the exchange rate of their currencies in a
certain range in a fixed form. The System combines factors from floating and pegged to
allow the market factors to have an effect on the exchange rate of a given country or other
competitive advantages in the countrys exports and imports.
Advantages of Target Zone Exchange Rate System
The system is known to reduce risks in international trade by maintaining a fixed rate
of the currency. It offers room for buyers and sellers from a given country to agree over a
given price of services or goods (Obstfeld, Shambaugh & Taylor, 2005).
Secondly, the system eliminates destabilizing speculations. Speculation flows can be

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very destabilizing for an economy and the incentives to speculate are very small when the
existing exchange rate is targeted.
Disadvantages of Target Zone Exchange Rate
The system does not allow automatic balance of payments adjustments. Target zone
exchange rates require the government or central bank to hold large reserves of foreign
currency to maintain a fixed rate- this reserve creates an opportunity cost.

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References
Arestis, P., & Demetriades, P. (1997). Financial development and economic growth: Assessing
the evidence*. The Economic Journal, 107(442), 783-799.
Buiter, W. H., & Grafe, C. (2012). Anchor, float or abandon ship: exchange rate Systems for the
accession countries. PSL Quarterly Review, 55(221).
Hill, C. W., & Jain, A. K. (2007). International business: Competing in the global marketplace
(Vol. 6). New York, NY: McGraw-Hill/Irwin.
Obstfeld, M., Shambaugh, J. C., & Taylor, A. M. (2005). The trilemma in history: tradeoffs
among exchange rates, monetary policies, and capital mobility. Review of Economics and
Statistics, 87(3), 423-438.