Tuesday, February 3, 2009

Exchange rate system

An exchange rate is the current market price for which one currency can be exchanged for another. If the U.S. exchange rate for the Canadian Dollar is $1.60, this means that 1 American Dollar can be exchanged for 1.6 Canadian dollars.
Exchange Rate Systems is of three types:

(1) Free-Floating Systems

A free-floating exchange rate system is one in which governments and central banks do not participate in the foreign exchange market.

The free-floating exchange rate system is a theoretical system only.

The advantage of a free-floating exchange rate system is self-regulation.

The disadvantage of a free-floating exchange rate system is the unpredictability of the exchange rate.

(2)Managed Float Systems

A managed float is a system of floating exchange rates in which some governments or central banks seek to influence their exchange rates.

A government or central bank cannot control the exchange rate but they often try to influence their rate at least for a short time.

(3)Fixed Exchange Rates

A system of fixed exchange rates is one in which exchange rates are fixed by government policy.

A Commodity Standard

A commodity standard system is a fixed exchange rate system in which the prices of various currencies are fixed relative to a given quantity of some commodity.

The most important commodity standard system in history is the gold standard.

In order to print money, gold had to be owned by a particular country and international payments had to be redeemable in gold at the stated rate.

The gold standard was self-regulating.

The self-regulation system required that adjustments to international imbalances come through massive changes in the economy.

Fixed Exchange Rates through Currency Board Arrangements

A currency board arrangement is a kind of commodity standard fixed exchange rate system in which there is explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed rate and a currency board to ensure fulfillment of the legal obligations this arrangement entails.

The simplest version is to only issue domestic currency when the currency board has an equivalent amount of the foreign currency to which the domestic currency is pegged.

This system severely limits an independent monetary policy by the country with the currency board.

Fixed Exchange Rates through Intervention

The post World War II system was set at Bretton Woods by international agreement.

Currencies were fixed in value in terms of other currencies.

Currency values were maintained by active intervention of governments and central banks by adjusting monetary and fiscal policies.

The unwillingness of countries to subjugate their monetary/fiscal policies to international considerations caused the breakdown of the system.

The United States withdrew from the Bretton Woods system when President Nixon announced the United States would no longer redeem foreign-held dollars for gold.

Fixed exchange rate systems make exchange rates more predictable.

Once exchange rates diverge significantly from their set values, bringing them back in line is very disruptive.

Coordinating monetary and fiscal policies to maintain exchange rates is not impossible, as the eleven-member European Union with its common currency, the euro, attests.

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