Flexible Exchange Rate System
Introduction: After the collapse of Bretton Woods System, IMF constituted a committee to evolve a new international monetary system. The committee members came out with a new set of rules which were formally accepted by all member countries in a meeting at Jamaica, in January 1976. With this came the System of Flexible Exchange Rates, where the exchange rate is not fixed by government authorities, rather it is determined by the market forces of demand and supply of the currencies in international market.
Under the new exchange rate system, a country can choose from one of the following options :-
(1) Managed Float System: Under the system of managed floating, a country's monetary authorities intervenes directly or indirectly to stabilize the exchange rate and to keep it within desired limits. It is also known as Dirty Floating.
a.) In case of Direct Intervention, the monetary authorities attempt to stabilize the exchange rate by buying and selling the foreign currency in the domestic market. When it buys foreign currency, its demand increases and the domestic currency depriciates against foreign currency. When it sells foreign currency, its supply increases and the domestic currency appreciates against foreign currency.
b.) In case of Indirect Intervention, the monetary authorities bring changes in the interest rates to stabilize the exchange rates and flush out the excess volatility.
Some of the countries which are following this system are India, Russia, Egypt, Singapore and Thailand.
(2) Free Float System: Under this system, the exchange rate is determined solely by the forces of demand and supply and it does not involve intervention. However, in practice some intervention is found in free float as well typically to prevent any undue fluctuations in the exchange rate. The system is also known as Clean Float System or Independent Float System.
Some of the countries following this system are United States, United Kingdom, Japan, Switzerland, Brazil, Canada and Mexico.
(3) Crawling Peg System: This system is a hybrid of fixed and floating exchange rate system. Under this system, the country establishes the par value of its currency in relation to a foreign currency, and then allows the par value to change gradually along with changes in the factors like Inflation.
A country can either peg its currency to a single currency or to a basket of currencies.
:- Countries like Jordan, Iraq, Bahamas, Saudi Arabia, and Qatar pegged their currencies to a single currency.
:- Countries like Fiji, Libya, and Morocco pegged their currencies to a basket of currencies.
(4) Currency Board Arrangement: A country following this system has a currency board which pegs the domestic currency to a foreign currency and allows the unlimited exchange of domestic currency for the foreign currency at a fixed exchange rate.
a.) In this system, the currency board is required to build the reserves of foreign currency at the fixed exchange rate, equivalent to the amount of domestic currency it has issued.
b.) With this system, the money supply can be controlled effectively because additional currency will be issued only if there are foreign currency reserves to back it. It also helps to keep a check on inflation.
The example of this system includes Hong Kong, which pegged its currency to US dollar.
(5) Target Zone Arrangement: In this system, a group of nations with common goals and interests, agree to either maintain the exchange rate within the specified band or to replace their domestic currency with a common currency.
An example of this system is European Monetary System, which was introduced in 1979.
In our next post, we will understand European Monetary System, Thank you....
Please drop your valuable feedback/Queries in comments section, i will revert on the same, and let me know the topics in which you are facing difficulties, i will acknowledge the same.
Introduction: After the collapse of Bretton Woods System, IMF constituted a committee to evolve a new international monetary system. The committee members came out with a new set of rules which were formally accepted by all member countries in a meeting at Jamaica, in January 1976. With this came the System of Flexible Exchange Rates, where the exchange rate is not fixed by government authorities, rather it is determined by the market forces of demand and supply of the currencies in international market.
Under the new exchange rate system, a country can choose from one of the following options :-
(1) Managed Float System: Under the system of managed floating, a country's monetary authorities intervenes directly or indirectly to stabilize the exchange rate and to keep it within desired limits. It is also known as Dirty Floating.
a.) In case of Direct Intervention, the monetary authorities attempt to stabilize the exchange rate by buying and selling the foreign currency in the domestic market. When it buys foreign currency, its demand increases and the domestic currency depriciates against foreign currency. When it sells foreign currency, its supply increases and the domestic currency appreciates against foreign currency.
b.) In case of Indirect Intervention, the monetary authorities bring changes in the interest rates to stabilize the exchange rates and flush out the excess volatility.
Some of the countries which are following this system are India, Russia, Egypt, Singapore and Thailand.
(2) Free Float System: Under this system, the exchange rate is determined solely by the forces of demand and supply and it does not involve intervention. However, in practice some intervention is found in free float as well typically to prevent any undue fluctuations in the exchange rate. The system is also known as Clean Float System or Independent Float System.
Some of the countries following this system are United States, United Kingdom, Japan, Switzerland, Brazil, Canada and Mexico.
(3) Crawling Peg System: This system is a hybrid of fixed and floating exchange rate system. Under this system, the country establishes the par value of its currency in relation to a foreign currency, and then allows the par value to change gradually along with changes in the factors like Inflation.
A country can either peg its currency to a single currency or to a basket of currencies.
:- Countries like Jordan, Iraq, Bahamas, Saudi Arabia, and Qatar pegged their currencies to a single currency.
:- Countries like Fiji, Libya, and Morocco pegged their currencies to a basket of currencies.
(4) Currency Board Arrangement: A country following this system has a currency board which pegs the domestic currency to a foreign currency and allows the unlimited exchange of domestic currency for the foreign currency at a fixed exchange rate.
a.) In this system, the currency board is required to build the reserves of foreign currency at the fixed exchange rate, equivalent to the amount of domestic currency it has issued.
b.) With this system, the money supply can be controlled effectively because additional currency will be issued only if there are foreign currency reserves to back it. It also helps to keep a check on inflation.
The example of this system includes Hong Kong, which pegged its currency to US dollar.
(5) Target Zone Arrangement: In this system, a group of nations with common goals and interests, agree to either maintain the exchange rate within the specified band or to replace their domestic currency with a common currency.
An example of this system is European Monetary System, which was introduced in 1979.
In our next post, we will understand European Monetary System, Thank you....
Please drop your valuable feedback/Queries in comments section, i will revert on the same, and let me know the topics in which you are facing difficulties, i will acknowledge the same.
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