Kinds of Exchange Rate Systems

Exchange Rate History

Exchange Rate :-( 1876-1913)
The nineteenth century highlights the importance of the gold standard as the exchange rate standard in that era. From 1876 to 1913, the exchange rate system was dependent on the respective currencys comparative convertibility to an ounce of gold. Later on, this system was reassessed when gold standard was suspended in World War 1.

Exchange Rate History :-( 1914-1944)

The exchange rate system was collapsed with the suspension of gold standard in 1914. In the early 1920s, some countries tried to revive the gold standard to get the old exchange system back into practice but all in Vail as the Great Depression hit the United States in 1929 and effects of which were felt by most of the developed world. Close to the end of World War II, the Bretton Woods Agreement was signed. The Bretton Woods Agreement founded a system of fixed exchange rates in which the currencies of all countries were pegged to the US dollar, which in turn was based on the gold standard.

Exchange Rate History: 1944 - 1971

The Bretton Woods Agreement remained in effect till 1971. In the 1970s, The Nixon-led US government suspended the convertibility of the national currency into gold. The supply of the US dollar had exceeded its demand. In 1971, the Smithsonian Agreement was signed and for the first time in exchange rate history, the market forces of supply and demand began to determine the exchange rate.

Exchange Rate History: The Floating System

The Smithsonian Agreement did not last very long. By 1973, the extensively traded currencies were permitted to fluctuate. In a floating currency system, a currencys value is allowed to vary in keeping with the conditions of the foreign exchange market. The advantage of a floating exchange rate system is that it is self attuned. A floating currency system allows greater liquidity and central bank control, but can be subject to attacks by speculators, or sudden panic-driven moves by investors that lead to currency crises and recessions.

International Finance 1

Kinds of Exchange Rate Systems

Definition of Exchange Rate System

The exchange rate system is the way a country manages its currency in respect to foreign currencies and the foreign exchange market.

Kinds of Exchange Rate Systems

Fixed and Floating are the two extreme exchange rate systems and in between these two many combinations of exchange rate regimes can be possible which may be partly fixed and partly floating.

A.Fixed Exchange Rate System

A fixed exchange rate system is in which a country tries to keep the value of its currency at a certain level against another currency through government intervention.

Example:
If a country fixes its currency to the British pound, it must hold enough pounds in reserve to account for all of its currency in circulation. Importantly, fixed exchange rates do not change according to market conditions. It is also called a pegged exchange rate. For example, the European Exchange Rate Mechanism ERM was a semi fixed exchange rate system.

Advantages:
Fixed exchange rate system is claimed to have the following advantages:

1. Avoid Currency Fluctuations:

Fluctuations in the currency pose uncertainty to those who are involved in the international trade. For example if a Pakistan firm is exporting to the US, a rapid appreciation in Pak rupees would make its exports uncompetitive and therefore may go out of business. If a firm relied on imported raw materials a devaluation would increase the costs of imports and would reduce profitability

2. Stability encourages investment .

The uncertainty posed by exchange rate fluctuations can also reduce the incentive for firms to invest in export capacity. Some Japanese firms have said that the UK's reluctance to join the Euro and provide stable exchange rate has made the UK a less desirable place to invest.

3. Keep inflation Low .

International Finance 2

Kinds of Exchange Rate Systems

Governments who allow their exchange rate to devalue may cause inflationary pressures to occur. This is because Aggregate Demand increases, import prices increase and firms have less incentive to cut costs. Joining a fixed exchange rate may cause inflationary expectations to be lower

4. Exchange Rate appreciation:

Lastly, A rapid appreciation in the exchange rate will badly affect manufacturing firms who export resulting in adverse current account.

Disadvantages:
The following are the main drawbacks of the system of fixed exchange rates:

1. Conflict with other objectives.

To maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives. If a currency is falling below its band the government will have to intervene. It can do this by buying dollars but this is only a short term measure. The most effective way to increase the value of a currency is to raise interest rates. This will decrease circulation of money and also reduce inflationary pressures. However higher interest rates will cause lower Aggregate Demand and economic growth, if the economy is growing slowly this may cause a recession and rising unemployment.

2. Less Flexibility.
It is difficult to respond to temporary shocks. For example an oil importer may face a deficit BOP if oil price increases, but in a fixed exchange rate there is little chance to devalue.

3. Join at the Wrong Rate.

It is difficult to recognize the right rate to join at. It If the rate is too high, it will make exports uncompetitive. If it is too low, it could cause inflation.

4. Current Account Imbalances.

Lastly, fixed exchange rates can lead to current account imbalances. For example, an overvalued exchange rate could cause a current account deficit.

5. International Investment not Promoted by Fixed Rates:

The argument that long-term international investments are encouraged under fixed exchange rate system is not valid. Both the lenders and borrowers cannot expect the exchange rate to remain stable over a very long-period.

6. Fixed Rates not Necessary for currency Area:

This stable exchange rate is not necessary for any system of currency areas. The sterling block functioned smoothly during the thirties in spite of the fluctuating rates of the member countries.

International Finance 3

Kinds of Exchange Rate Systems

7. Speculation not Prevented by Fixed Rates:

The main weakness of the stable exchange rate system is that in spite of the strict exchange control, currency speculation is encouraged. This destroys the stability in the exchange value of the home currency and makes devaluation of the currency inevitable. For instance, the pound had to be devalued in 1949 mainly because of such speculation.

B. Floating Exchange Rate System

An exchange rate between two currencies that is allowed to fluctuate with the market forces of supply and demand is called floating exchange rate. It tends to result in uncertainty as to the future rate at which currencies will exchange. This uncertainty is responsible for the increased popularity of forward, futures, and option contracts on foreign currencies.

Advantages:
Flexible exchange rate system is claimed to have the following advantages:

1. Independent Monetary Policy:

Under flexible exchange rate system, a country is not dependent upon another country as happen with fixed rate system. It can adopt independent policies to run its domestic affairs properly.

2. Shock Absorber:
A floating rate system acts as a shock absorber and saves the economy against changes in other countries

3. Promotes Economic Development:

The floating rate system also promotes economic growth and boosts employment in the country. The exchange rates can be changed in accordance with the requirements of the monetary policy of the country to achieve the planned national objectives.

4. Solutions to Balance of Payment Problems:

The system of flexible exchange rates automatically removes the disequilibrium in the balance of payments. When, there is deficit in the balance of payments, the external value of a country's currency falls. As a result, exports are encouraged, and imports are discouraged thereby, establishing equilibrium in the balance of payment.

5. Promotes International Trade:

Floating exchange rate system promotes free trade and flow of goods and services between countries if the trend of the rate of exchange is generally assessed through the forward market and the traders are protected from financial losses arising from fluctuating exchange rates.

International Finance 4

Kinds of Exchange Rate Systems

6. Increase in International Liquidity:

The system of flexible exchange rates eliminates the need for official foreign exchange reserves, if the individual governments do not employ stabilization funds to influence the rate. Thus, the problem of international liquidity is automatically solved.

7.

Market Forces at Work:

Under the flexible exchange rate system, the foreign exchange rates are determined by the market forces of demand and supply.

8. Long Term International Investment:

Floating rate system stimulates investors for long term investments as the rate is assessed through forward markets protecting them from exchange rate fluctuations.

Disadvantages:
The following are the main drawbacks of the system of floating exchange rates:

1. Low Elasticity:
Firstly the elasticity in the international markets is too low for exchange rate. When import and export elasticity is very low, the exchange market becomes unstable. Hence, the depreciation of the weak currency would simply tend to worsen the balance of payments deficit further.

1. Unstable conditions:
Floating exchange rates create conditions of instability and uncertainty which, in turn, tend to reduce the volume of international trade and foreign investment. Long-term foreign investments are greatly reduced because of higher risks involved.

2. Adverse Effect on Economic Structure:

Floating rate put adverse effects on the economic growth. The exchange rates cause changes in the price of imported and exported goods which, in turn, destabilize the economy of the country.

3. Unnecessary Capital Movements:

By encouraging speculative activities, floating rate system causes large-scale capital outflows and inflows, thus, seriously disturbing the economy of the country.

4. Depression Effects of Capital Movements:

As a result of Speculative capital movements caused by fluctuating exchange rates, extremely high liquidity preference may occur. In such a situation, people tend to hoard currency, interest rates rise, investment falls and there is large-scale unemployment in the economy.

International Finance 5

Kinds of Exchange Rate Systems

5. Inflationary Effect:
Floating exchange rate system involves greater possibility of inflationary effect of exchange depreciation on domestic price level of a country. In turn rise in prices leads to further depreciation of the external value of the currency.

6. Factor Immobility:
The immobility of various factors of production deprives the flexible exchange rate system of its advantages arising from the adoption of monetary and other policies for maintaining internal stability. Such policies produce desirable effects on production and employment only when supply of factors of production is elastic.

7. Failure of Flexible Rate System:

Experience of the flexible exchange rate system adopted between the two world wars has shown that it was a flop.

C. Managed Float Exchange Rate System

A managed floating rate systems is a hybrid of a fixed exchange rate and a flexible exchange rate system. In a country with a managed floating exchange rate system, the central bank becomes a key participant in the foreign exchange market. A managed float is also known as a dirty float.

Example:
Suppose that Thailand had a managed floating rate system and that the Thailand central bank wants to keep the value of the Baht close to 25 Baht/$. In a managed floating system, the Thai central bank is willing to tolerate small fluctuations in the exchange rate (say from 24 to 26) without getting involved in the market. If, however, there is excess demand for Baht in the rest of the market causing appreciation below the 24 Baht/$ level the Central Bank increases the supply of Baht by selling Baht for dollars and acquiring holdings of dollars. Similarly if there is excess supply of Baht causing depreciation above the 26 Baht/$ level, the Central Bank increases the demand for Baht by exchanging dollars for Baht and running down its holdings of dollars. So under a managed floating regime, the central bank holds foreign exchange reserves. It is also important to realize that a managed float can only work when the implicit target is close to the equilibrium rate that would prevail in the absence of central bank intervention. Otherwise, the central bank will deplete its foreign exchange reserves and the country will be in a flexible exchange rate system because they can no longer intervene.

International Finance 6

Kinds of Exchange Rate Systems

Advantages:
Managed exchange rate system is claimed to have the following advantages:

1. Balance between fixed and floating rate systems

It recognizes the benefits of a flexible exchange rate automatically adjusting to equilibrium in response to foreign exchange market disruptions. However, it also recognizes that the resulting exchange rate might not always generate desired international trade patterns and that government might need to step in to fix the rate temporarily.

2. It allows nations to pursue independent monetary policies

Under a fixed rate system; fixed either by agreement or by gold, a nation with merchandise trade deficit might have to enact a tight monetary policy to retard inflation and promote trade. This type of action is not needed with managed float, the proponents of which claim that solving trade deficit by adjusting one price-the exchange rate- is better than adjusting price level.

3. It solves trade problems without trade restrictions

In fixed rate systems, nations balance trade deficits by imposing tariffs and quotas but in managed float this is done through setting exchange rate.

4. Easily adjustable to shocks

During 1973-1974 the OPEC countries dramatically raised the prices of oil thus resulting in trade deficit of many oil importing countries. Fixed rate system had a hard time for accommodating for such a disaster. But with managed float, the exchange rate took most of the shock and enabled nations to weather the storm with minimum of difficulty.

Disadvantages
The following are the main drawbacks of the system of managed exchange rates:

1. Promotes International Trade:

It promotes exchange rate volatility and uncertainty resulting in less international trade than would be possible with fixed exchange rate.

2. It promotes inflation
Managed float rate system frees nations to inflate, predicting that more inflation would occur than under the fixed exchange rate.

3. No immediate effects
Changes in the exchange rate alter trade balances in the desired direction only after a long period of time. In the short run, depreciation in a currency can make the situation worse instead of better.

International Finance 7

Kinds of Exchange Rate Systems

D.

Crawling Pegs Exchange rate System

A system of exchange rate adjustment in which a currency with a fixed exchange rate is allowed to fluctuate within a band of rates. The par value of the stated currency is also adjusted frequently due to market factors such as inflation. This gradual shift of the currency's par value is done as an alternative to a sudden and significant devaluation of the currency.

Example:
In the 1990s, Mexico had fixed its peso with the U.S. dollar. However, due to the significant inflation in Mexico, as compared to the U.S., it was evident that the peso would need to be severely devalued. Because a rapid devaluation would create instability, Mexico put into place a crawling peg exchange rate adjustment system, and the peso was slowly devalued toward a more appropriate exchange rate.

Advantages:
Pegged exchange rate system is claimed to have the following advantages:

1. Avoids Economic Instability

It avoids the economic instability. Countries will adopt such a system when they know that macroeconomic conditions are likely to lead to a market clearing rate that is steadily depreciating, thus making it unlikely that any fixed rate can be sustained for more than a short period of time.

2. Reduces Uncertainty
It reduces uncertainty due to volatility characterizing floating exchange rate. Many countries have a history of fixed exchange rate systems that have very frequent devaluations. Since, each devaluation brings with it considerable uncertainty and turmoil, some countries (like Brazil at various points in its history) have adapted a system known as a crawling peg exchange rate system.

3. Pre Arrangements for combating uncertainty

By pre-announcing the devaluations, the uncertainty about when exactly the devaluation will occur is taken out of the picture. This greatly reduces the accompanying economic turmoil.

Disadvantages:
The following are the main drawbacks of the system of pegged exchange rates:

1. Need for Currency Realignment

It might prompt monetary authorities to accelerate their currency realignment.

2. Pegging Frequency

International Finance 8

Kinds of Exchange Rate Systems

Graphically, a crawling peg looks like a step function. Of course the more frequently the peg is adjusted the more likely a crawling peg resembles a flexible exchange rate system, and the less often the peg is adjusted, the more it resembles a fixed exchange rate system.

Conclusion
The fact that there exist such a diversity of exchange rate practices around the world seems to indicate that there is no simple, universal prescription. The choice must depend upon the countrys circumstances. Each of the broad kinds of systems mentioned above has its own advantages as well as disadvantages. It is up to the countrys government to chose an appropriate system at the right time to implement its economic policies and help the economy prosper.

International Finance 9

Kinds of Exchange Rate Systems

References:
http://www.investopedia.com/terms/c/crawlingpeg.asp#ixzz1wiGDOh3a http://money.howstuffworks.com/exchange-rate2.htm http://www.economicshelp.org/macroeconomics/exchangerate/advantages-disadvantagesfixed.html http://www.preservearticles.com/201012291898/advantages-disadvantages-flexible-exchangerates.html http://www.nptel.iitm.ac.in/courses/110105031/pr_pdf/Module8.8pdf.pdf

International Finance 10

Kinds of Exchange Rate Systems

1. References:
Ministry of Textile Sbp.org.pk/departments/stats World Trade Organization http://www.aptma.org.pk/Pak_Textile_Statistics/tec.ASP http://www.aptma.org.pk/Pak_Textile_Statistics/ecloth.asp http://www.pakistantrade.org/tradebulletin/tradebulletin6.pdf

International Finance 11