Exchange Rates

This section explores the determination of exchange rates under different monetary systems, focusing on fixed and managed exchange rate regimes.

Determination of Exchange Rates: Fixed Exchange Rate System

Definition

A fixed exchange rate system is where a country's government or central bank pegs the value of its currency to another currency or a basket of currencies. The exchange rate is set and maintained at a specific level.

How it Works

1. The central bank intervenes in the foreign exchange market to maintain the fixed rate.
2. If the domestic currency's value falls below the target, the central bank buys its own currency, increasing demand and pushing the value up.
3. If the domestic currency's value rises above the target, the central bank sells its own currency, increasing supply and pushing the value down.

Advantages of a Fixed Exchange Rate

• Provides exchange rate stability, which can be beneficial for international trade and investment.
• Reduces uncertainty for businesses involved in international transactions.
• Can help to control inflation if the fixed rate is set at a low level.

Disadvantages of a Fixed Exchange Rate

• Limits the central bank's ability to use monetary policy to address domestic economic problems.
• Can lead to speculative attacks if investors believe the fixed rate is unsustainable.
• Requires significant foreign exchange reserves to defend the fixed rate.

Example

The European Exchange Rate Mechanism (ERM) was a system of fixed exchange rates used by many European countries before the introduction of the Euro.

Table: Advantages and Disadvantages of a Fixed Exchange Rate

Advantages	Disadvantages
Exchange rate stability	Limits monetary policy
Reduced uncertainty	Speculative attacks possible
Inflation control (potentially)	Requires large reserves

Determination of Exchange Rates: Managed Exchange Rate System

Definition

A managed exchange rate system is where a country's government or central bank intervenes in the foreign exchange market to influence the value of its currency, but does not fix it at a specific level. The exchange rate is allowed to fluctuate within a certain range.

How it Works

The central bank intervenes to smooth out exchange rate fluctuations, typically by buying or selling its own currency.

Advantages of a Managed Exchange Rate

• Provides some exchange rate stability while still allowing for monetary policy flexibility.
• Can help to reduce excessive volatility in the exchange rate.
• Offers a middle ground between a fixed and a floating exchange rate system.

Disadvantages of a Managed Exchange Rate

• Less certainty than a fixed exchange rate system.
• Requires ongoing intervention by the central bank.
• Can be difficult to manage effectively.

Example

Many countries, including India and Singapore, operate managed exchange rate systems.

Table: Advantages and Disadvantages of a Managed Exchange Rate

Advantages	Disadvantages
Some exchange rate stability	Less certainty than fixed
Reduces volatility	Requires intervention
Flexibility with monetary policy	Difficult to manage effectively

Determination of Exchange Rates: Floating Exchange Rate System

Definition

A floating exchange rate system is where the value of a currency is determined by the forces of supply and demand in the foreign exchange market. The government or central bank does not intervene.

How it Works

The exchange rate fluctuates based on the relative supply and demand for the currency.

Advantages of a Floating Exchange Rate

• Allows monetary policy to be used to address domestic economic problems.
• Reflects underlying economic fundamentals.
• Reduces the need for foreign exchange reserves.

Disadvantages of a Floating Exchange Rate

• Can lead to exchange rate volatility, which can be disruptive to international trade and investment.
• Creates uncertainty for businesses involved in international transactions.

Example

The United States, the United Kingdom, and Japan have floating exchange rate systems.

Table: Advantages and Disadvantages of a Floating Exchange Rate

Advantages	Disadvantages
Monetary policy flexibility	Exchange rate volatility
Reflects economic fundamentals	Uncertainty for businesses
No need for large reserves