CH 3 CURRENT EXCHANGE RATE SYSTEM EXCHANGE RATE

CH. 3 CURRENT EXCHANGE RATE SYSTEM

EXCHANGE RATE SYSTEM • Exchange rates can be classified as ü Fixed Exchange Rate – Rigid Peg / Crawling Peg ü Flexible Exchange Rate - Free Float / Managed Float • The other methods include ü Currency Board ü Currency Basket ü Co-operatives

• After the collapse of BWS, the IMF appointed a committee of 20 that suggested for various options for exchange rate arrangement. • Those suggestions were approved at Jamaica during February 1976 & were formally incorporated into the next of the Second Amendment to the Articles of Agreement that came into force from April 1978. • The options were 1. Floating - independence & managed 2. Pegging of Currency 3. Target zone arrangement

FIXED EXCHANGE RATES • In this system, the monetary authority fixes the value of the domestic currency to a foreign currency or a basket of currencies. • It is also called as hard peg or rigid peg. • One currency is pegged to a foreign currency & its value is set at regular intervals according to some preset criteria by the Central Bank & the new value is decided on the basis of average exchange rate of the previous few months which makes the system more responsive, this system is called as crawling peg system.

FEATURES OF FIXED EXCHANGE RATE SYSTEM • The currency in which the domestic currency is pegged should be freely convertible. • Central Bank intervention in determination of price of the currency is another important element of this system. • The Central Bank does not only fixes the price but can also buy & sell the currencies & it is the responsibility of the Central Bank to maintain adequate foreign currency reserves.

ADVANTAGES OF FIXED EXCHANGE RATE SYSTEM • Contribute to the strength of domestic currency: Since there is no currency fluctuations, fixed exchange rate creates assurance in the strength of the domestic currency. • Contributing to International Economic Integration: Fixed exchange rate is a part of a more universal argument for national economic policies contributing to international economic integration.

• Control of Inflation: As Central Bank controls the money supply therefore, inflation is under control. The Central Bank’s intervention ensures that the rates can be changed as per the requirements of the economy, thus helping government fight inflation in the economy. • Elimination of Depreciation of Currencies: Under the fixed exchange rate system, there is no unhealthy practice of depreciation of currencies to capture international trade.

• Encourage Long term Capital Flows: Sine uncertainty & risk of exchange rates volatility is rare in case of fixed exchange rate, it encourages long term capital flows. • Encourages International Trade: Commitment to single fixed exchange rate encourages international trade by making prices of goods more predictable. • Relatively Simpler System: It is a relatively simpler system & can be relied upon as there are no frequent fluctuations in the exchange rate.

• Monitor Responsible Financial Policies: Fixed exchange rate serves as a commentator & imposes a discipline on monetary authorities to monitor responsible financial policies within countries. • Comparatively more Stainable: The exchange rate remain stable as compared to flexible exchange rate. • Absence of Exchange Rate Risk: In the case of fixed exchange rate system, there is no risk of exchange rate changes which will be beneficial in international trade & foreign investment flows.

• No fear of Unfavorable effect of Speculation: Since there is no fear of currencies fluctuations, fixed exchange rate creates confidence in the strength of the domestic currency & there is no fear of adverse effect of speculation on the exchange rate. The stable exchange rate avoids the harming possibilities of speculation & so there is no fear of unfavorable effect of speculation on the exchange rate under fixed exchange rate system.

Disadvantages of Fixed Exchange Rate System • Affects Domestic Economic Stability: Fixed exchange rate possibly will achieve exchange rate stability but at the cost of domestic economic stability. The exchange rates do not reflect the macroeconomic changes taking place in the economy. • International Trade not promoted by Fixed Rate: The argument that fixed exchange rates promote international trade is not supported by historical facts of inter-war or post-war period.

• Restrictions on Monetary Policy Formulation: Monetary authorities lose the freedom of monetary policy formulation to preserve exchange rate stability. Any instability in exchange rate needs to be corrected by buying or selling foreign exchange reserves or by controlling the domestic money supply. • Managing Foreign Exchange Reserves: The Central Bank may have to maintain adequate reserves of the foreign currency every time leading to idle resources. To protect the fixed exchange rate, country needs to have sufficient foreign exchange reserves & this imposes heavy load on monetary authorities for managing reserves

• Misallocation of Resources: Fixed exchange rate system need difficult exchange control mechanism which may lead to misallocation of resources. This system may result into either huge accumulation of reserves or a drain of a country’s foreign exchange reserves which may cause severe BOP problems. • International Trade & Investment not Promoted by Fixed Rates: The argument that long term international trade & investments are encouraged under fixed exchange rate system is not valid. The lenders & the borrowers cannot expect the exchange rate to remain stable over a very long period.

• Fixed Rates not Necessary for Currency Area: The stable exchange rates are not necessary for any system of currency areas. • Regular Intervention of the Central Bank: This system requires regular intervention of the Central Bank to stabilize the rate, however, underlying problems of the weak economy could not be solved through this method. • Cannot Adjust the Inflow & Outflow of Currency Automatically: The fixed exchange rate system does not prove to be self-balancing mechanism as it cannot adjust the inflow & outflow of currency automatically.

FLUCTUATING EXCHANGE RATES • When the exchange rate of a currency is determined by the market forces i. e. demand & supply of the currency, it is called as floating or flexible exchange rate. • When the exchange rate is purely determined by the market forces, it is called as free float or clean float. • However, when along with the market forces, monetary authority’s intervention is allowed to influence the exchange rate of the currency, it is called as managed float or dirty float.

• In this method, the Central Government does not