Different Exchange Rate Systems with Pros and Cons

Different Exchange Rate Systems. The conversion rate of one currency into another. This rate depends on the local demand for foreign currencies and their local supply, country’s trade balance, the strength of its economy, and other such factors.
In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, FX rate or Agio) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency.

Different Exchange Rate Systems

Exchange rate systems may be classified according to the degree by which exchange rates are controlled by the govt. Exchange rate systems normally fall into one of the following categories, each of which is discussed in turns:

1. Fixed
2. Freely fixed
3. Managed float
4. Pegged

Fixed Exchange Rate System.

In a fixed exchange rate system, exchange rates either held constant or allowed to fluctuate only within very narrow boundaries. A fixed exchange rate system requires much central bank intervention in order to maintain a currency’s value within narrow boundaries. In general, the central bank has to offset any imbalance between demand and supply conditions for its currency in order to prevent its value from changing.

Advantages of Fixed Exchange Rate System.

1. Exporters & importers could engage in international trade without concern about exchange rate movements of the currency to which their local currency is linked.
2. Firms could engage in direct foreign investment without concern about exchange rate movements of that currency.
3. Investors would be able to invest funds in foreign countries without concern that the currency dominating their investments might weaken over time.
4. A country with a stable exchange rate can attract more funds as an investment.

Disadvantages of Fixed Exchange Rate System.

1. There is still a risk that the govt. will alter the value of a specific currency.
2. It may make each country and its MNCs more vulnerable to economic conditions in other countries.

Freely Floating Exchange Rate System.

In a freely floating exchange rate system, exchange rate values are determined by market forces without intervention by governments. Whereas a fixed exchange rate system allows no flexibility for exchange rate movements, a freely floating exchange rate system allows complete flexibility. A freely floating exchange rate adjusts on a continual basis in response to demand and supply conditions that currency.

Advantages of the Freely Floating Exchange Rate System.

1. A country is more insulated from the inflation of other countries.
2. A country is more insulated from unemployment problems in other countries.
3. The central bank isn’t required to constantly maintain exchange rates within specified boundaries.
4. Investors would invest funds in whatever country had the highest interest rate.

Disadvantages of the Freely Floating Exchange Rate System.

1. A country is somewhat insulated from the problems experienced in another country due to the freely floating exchange rate system.
2. It can adversely affect a country that has high unemployment.

Managed Float Exchange Rate System.

The exchange rate system that exists today for most currencies lies somewhere between fixed and freely floating. It resembles the freely floating system in that exchange rates are allowed to fluctuate on a daily basis and there are no official boundaries. It is similar to the fixed-rate system in that governments can and sometimes do intervene to prevent their currencies from moving too far in a certain direction. This type of system is known as a managed float or “dirty” float (as opposed to a “clean” float where rates float freely without government intervention). Different Exchange Rate Systems.

Advantages

1. The greatest advantage is that adjustments needed to achieve external equilibrium impact only indirectly on the domestic economy.
2. Monetary policy tends to be stronger.

Disadvantages

1. Different governments try to set their exchange rates at levels that are inconsistent with each other.
2. Countries may become involved in rounds of competitive devaluations in order to capture a competitive advantage.
3. It was expected that speculators would stabilize rates close to their PPP normal exchange rate equivalents.
4. Exchange rates have been over and undershooting their PPP normal exchange rate equivalent often because of interest rate policies and the movement of short term capital.
5. Fiscal policy tends to be weaker.

Criticism of a Managed Float System.

Critics suggest that a managed float system allows a government to manipulate exchange rates in a manner that can benefit its own country at the expense of others. A government may attempt to weaken its currency to stimulate a stagnant economy. The increased aggregate demand for products that result from such a policy may reflect a decreased aggregate demand for products in other countries, as the weakened currency attracts foreign demand. Although this criticism is valid, it could apply as well to the fixed exchange rate system, where governments have the power to devalue their currencies.

Pegged exchange rate

A pegged exchange rate system is a hybrid of fixed and floating exchange rate regimes. Typically, with a pegged exchange rate, an initial target exchange rate is set and the actual exchange rate will be allowed to fluctuate in a range around that initial target rate. Also, given changes in economic fundamentals, the target exchange rate may be modified.
Some countries use a pegged exchange rate arrangement, in which their home currency’s value is pegged to one foreign currency or to an index of currencies. While the home currency’s value is fixed in terms of the foreign currency to which it is pegged, it moves in line with that currency against other currencies.

Advantages

The advantages of pegged exchange rates include a reduction in the volatility of the exchange rate (at least in the short-run) and the imposition of some discipline on government policies. Different Exchange Rate Systems.

Disadvantages 

The basic disadvantage is that you do not control the value of your currency. If you peg it to the dollar, then the US Federal Reserve System determines whether you have inflation or deflation. If you believe a central bank should inflate your currency to stimulate your economy, or to discourage imports, you lose that ability. One disadvantage is that it can introduce currency speculation.

See Also.

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