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Forex Systems - Types

The document discusses two main types of exchange rate systems: fixed and floating. Under a fixed system the exchange rate is set by a government, while under a floating system it is determined by market forces. The document provides examples of different fixed systems like pegged rates and crawling pegs, as well as managed and free floating systems.

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7 views6 pages

Forex Systems - Types

The document discusses two main types of exchange rate systems: fixed and floating. Under a fixed system the exchange rate is set by a government, while under a floating system it is determined by market forces. The document provides examples of different fixed systems like pegged rates and crawling pegs, as well as managed and free floating systems.

Uploaded by

Divya Chaudhary
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Internation Business

Foreign Exchange Rate Systems


Types:
1. Fixed Exchange Rate System
2. Floating Exchange Rate System

1. Fixed Exchange Rate System

 In a fixed exchange rate system, the exchange rate is set


and maintained by the government or central bank.

 Where the value of a country's currency is fixed or pegged


to the value of another currency or a basket of currencies

 It does not fluctuate in response to market forces of supply


and demand.

a). Gold Standard: Under the gold standard, the value of a


country's currency is directly linked to a specific amount of
gold.
Countries on the gold standard would exchange their
currencies for gold at a fixed price.
The gold standard was widely used in the 19th and early 20th
centuries but has since been abandoned by most countries.
Internation Business
Pegged Exchange Rate: In a pegged exchange rate system, a
country fixes the value of its currency to another currency or a
basket of currencies.
Examples include the gold standard, where currencies were
pegged to gold, and the Bretton Woods system, where
currencies were pegged to the U.S. dollar.
A) Crawling Peg: A crawling peg is a system where the
exchange rate is fixed, but adjusted periodically to
account for inflation differentials or other economic
factors.
The adjustments are typically small and gradual, hence
the term "crawling."

B) Pegged-within-Bands: Some countries use a system


where the exchange rate is pegged within a certain range
or band.
The central bank intervenes to keep the exchange rate
within the band but allows for some flexibility in
response to changing economic conditions.
Internation Business
2. Floating Exchange Rate System

A floating exchange rate system is a type of exchange rate in


which a country's currency value is allowed to fluctuate freely
based on the forces of supply and demand in the foreign
exchange market.
The exchange rate is determined by market forces without
intervention from the government or central bank.

There are two main types of floating exchange rate systems:

Free Float: In a free float system, the exchange rate is


completely determined by market forces, and the government
or central bank does not intervene in the foreign exchange
market to influence the exchange rate.
The exchange rate fluctuates based on interest rates, inflation,
economic indicators, and market speculation.
Also known as free/clean float.

Example:
Imagine two countries, Country A and Country B, with their
respective currencies, Dollar ($) and Pound (£).
Both countries operate under a free float exchange rate
system, meaning the exchange rates between their currencies
are determined by market forces.
Internation Business
Initially, the exchange rate between $ and £ is 1 $ = 1 £.
However, due to market forces, the exchange rate begins to
change:

Scenario 1:
Market Demand for $: Suppose there is increased demand
for goods and services from Country A, leading to a higher
demand for $.
As a result, the exchange rate may change to 1 $ = 1.2 £,
indicating that $ has appreciated relative to £.
Scenario 2:
Economic Data Release: If economic data from Country B
shows strong growth, it may lead to an increase in demand for
£ and a decrease in demand for $.
This could cause the exchange rate to change to 1 $ = 0.8 £,
indicating that $ has depreciated relative to £.

Managed Float: In a managed float system, the government


or central bank may intervene in the foreign exchange market
occasionally to stabilize the currency or achieve specific
policy goals.
While the exchange rate is primarily determined by market
forces, the central bank may intervene to prevent excessive
volatility or to address imbalances in the economy.
Internation Business
It is sometimes referred to as a "dirty float."
The term "dirty float" suggests that the exchange rate is not
completely free-floating, as there are instances where the
authorities step in to influence the exchange rate.
These interventions can be aimed at stabilizing the currency,
managing inflation, boosting exports, or addressing other
economic objectives.
Example:
Imagine a country, Country X, with its currency, $, which
operates under a managed float exchange rate system.
The government or central bank of Country X monitors the
exchange rate between $ and another currency, say the Yen
(¥), and intervenes in the foreign exchange market when
necessary.

Scenario 1:
Exchange Rate Stability: If the $ is experiencing excessive
volatility or rapid appreciation/depreciation, the central bank
of Country X may intervene by buying or selling $ in the
foreign exchange market.
For example, if the $ is appreciating too quickly, the central
bank may sell $ to increase its supply and reduce its value
relative to the ¥.
Scenario 2:
Economic Policy Objective: Suppose Country X wants to
boost its exports by making its goods cheaper in international
markets. The central bank may intervene by selling $ and
Internation Business
buying ¥, effectively weakening the $ and making exports
more competitive.
Scenario 3:
External Shocks: If there is a sudden shock to the economy,
such as a financial crisis or natural disaster, the central bank
may intervene to stabilize the exchange rate and prevent
excessive depreciation of the $.

Floating exchange rate systems offer several advantages,


including:

Automatic Adjustments: Exchange rates adjust


automatically to changes in economic conditions, helping to
maintain balance in international trade.
Monetary Policy Independence: Countries with floating
exchange rates have more flexibility in conducting monetary
policy, as they are not constrained by the need to maintain a
fixed exchange rate.
Market Efficiency: Floating exchange rates reflect market
conditions and provide valuable information to businesses and
investors.

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