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Exchange Rate Mechanisms

Posted: Monday, 18 August, 2014. | By: Equipoise Bot

There are three types of Exchange Rate(ER) mechanisms:

  • Floating ER – no intervention by governments or central banks
  • Fixed ER – officials strive to keep the ER fixed (or pegged) even if the rate that they choose is not the equilibrium rate.
  • Managed Exchange Rates - fall in-between these two categories
Fixed Exchange rates
This form of exchange rates was predominantly used during the early 20th century (1900- 1970). In a fixed exchange rate the value of a currency is fixed or pegged to another fixed amount of a commodity or currency. For example, if India had ‘x’ kgs of gold and has printed Rs ‘y’, then each rupee is worth ‘x/y’ amount of gold. This is the fixed rate at which the currency is exchanged.
There are three rules when fixing a currency to a commodity.
  1. Fix the value of the currency unit in terms of gold (fixed exchange rate)
  2. Keep the supply of domestic money fixed in some constant proportion of the gold supply
  3. Countries must be willing to exchange gold for their own currency
 
In addition to commodities like gold, countries can fix their exchange rates to other currencies (like USD, Euro). It could also be pegged to a ‘basket’ of currency. Special Drawing Rights is one such example. It is maintained by the International Monetary Fund (IMF)
 
Advantages of Fixed Exchange Rates
  • Elimination of exchange rate risk, which can greatly enhance international trade and investment.
  • The discipline imposes on a country’s monetary authority due to fixed exchange rates, likely to result in a much lower inflation rate.
 
Disadvantages of Fixed Exchange Rates when pegged with other currencies
  • Fluctuations in the value of the particular currency to which the home country is pegged can produce needless volatility in the country’s international price competitiveness. For example, the appreciation of the dollar from 1995 and 2001 was also an appreciation for whatever currencies were linked to the dollar.
  • It is difficult to respond to temporary shocks. For example an oil importer may face a balance of payments deficit if oil price increases, but in a fixed exchange rate there is little chance to devalue.
  • The system of fixed exchange rates provides neither the expectation of permanently stable rates as found in the gold standard system nor the continuous and sensitive adjustment of a freely fluctuating exchange rate.
 
Floating exchange rates
 
Floating Exchange rates fluctuates based on the market supply and demand. The currency value is allowed to fluctuate according to the foreign exchange markets.
 
Advantages of Floating Exchange Rates
 
  • Absence of crises - Fixed rates are often characterised by crises as pressure mounts on a currency to devalue or revalue. The fact that, with a floating rate, such changes are automatic should remove the element of crisis from international relations.
  • Lower foreign exchange reserves - A country with a fixed rate usually has to hold large amounts of foreign currency in order to prepare for a time when they have to defend that fixed rate.
 
Disadvantages of Floating Exchange Rates
 
  • Uncertainty - The fact that a currency changes in value from day to day introduces instability or uncertainty into trade. Sellers may be unsure of how much money they will receive when they sell abroad or what their price actually is abroad.
  • Inflation - The floating exchange rate can be inflationary. Apart from not punishing inflationary economies, which, in itself, encourages inflation, the float can cause inflation by allowing import prices to rise as the exchange rate falls.
  • Lack of investment - The uncertainty can lead to a lack of investment internally as well as from abroad
  • Both Fixed and Floating Foreign Exchange mechanism has its own merits and demerits. A combination of both these mechanism can be used to eliminate some of the shortcomings. Managed Exchange Rates is one such solution. In managed exchange rates the central bank places some influence on an exchange rate that would otherwise be freely floating.
 
Points to ponder about:-
 
How does Managed exchange rate eliminate the disadvantages?

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