EXCHANGE RATE SYSTEMS

Initially, the IMF [International Monetary Fund: - the United Nations Monetary and Financial
Conference held in Bretton Woods, New Hampshire (in Northeastern U.S.) in July 1944, was
called to develop a structured international monetary system. As a result of this conference, the
International Monetary Fund – IMF was formed] recognized three types of currency exchange
rate systems, but it extended the categories to six subsequently. These six categories of exchange
rate systems that the IMF now uses to describe how countries position their currencies in
relation to other currencies are listed here below. Exchange rate systems can be classified
according to the degree by which exchange rates are controlled by Governments. They fall into
one of the following categories:

1. Fixed.
2. Managed float.
3. Pegged.
4. Currency boards
5. Freely floating.
6. Exchange rate system with no separate legal tender.
Each of these exchange rate systems is discussed below.
Fixed exchange rate system
In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate
only within very narrow boundaries. If an exchange rate begins to move too much, governments,
via their central banks, intervene to maintain it within the boundaries. In some situations, a
government will devalue or reduce the value of its currency against other currencies by changing
unfavourably the fixed exchange rate of its currency against that of a foreign currency. In other
situations, it will revalue or increase the value of its currency against other currencies by
changing favourably the fixed exchange rate of its currency against that of a foreign currency. A
central bank’s actions to devalue a currency is referred to as devaluation. The term depreciation
is also used, but in a different context. Devaluation refers to a downward adjustment of the
exchange rate by the central bank. Depreciation refers to a change caused by exchange rate
markets. Revaluation refers to an upward adjustment of the exchange rate by the central bank.
An upward adjustment by the market is referred to as an appreciation in the value of the
currency.
Example 1:
When UK companies imported materials from abroad during the fixed exchange rate era after
World War II, it could anticipate/predict the amount of British pounds it would need to pay for
imports.

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Subsequently, when the fixed exchange rate system era ended, when the British pound
depreciated in the late 1960s, UK companies needed more British pounds to purchase imports.
Example 2:
Where exchange rate is held constant:
Saudi Arabia has fixed the exchange rate of its riyal to the US Dollar at 3.75 riyals equal to $1.
Therefore, if you visit Saudi Arabia, you always know that $1 will buy you 3.75 Saudi riyals.
Saudi Arabia did that because its primary export, oil, is priced in U.S. dollars. All oil contracts
around the world are written and executed in dollars.
Advantages of a fixed exchange rate system
In a fixed exchange rate environment, Multinational Companies (MNCs) can engage in
international trade without worrying about the future exchange rate. MNCs are able to know with
certainty exactly how much of the domestic currency they will use to buy a certain amount of a
foreign currency because the foreign currency exchange rate is fixed.
Disadvantages of a fixed exchange rate system
Although a multinational company is not exposed to continuous movements in an exchange rate,
it does continuously face the possibility that the government will devalue or revalue its currency
when it moves too far away beyond the allowed narrow boundaries.
A second disadvantage is that from a macroeconomic viewpoint, a fixed exchange rate system
may make each country more vulnerable to economic conditions/problems in other countries.
Example
Assume the United States and the United Kingdom have a fixed exchange rate system between
them and that they trade frequently with each other. If the United States experiences a much
higher inflation rate than the United Kingdom, US consumers should buy more goods from the
United Kingdom and British consumers should reduce their imports of US goods (due to the high
US prices). This reaction would force US production down and unemployment up. It could also
cause higher inflation in the United Kingdom due to excessive demand for British goods relative
to the supply of British goods produced. Thus, the high inflation in the United States could cause
high inflation in the United Kingdom. In the mid and late 1960s, the United States experienced
relatively high inflation and was accused of “exporting” that inflation to some European
countries due to fixed exchange rate.

[Inflation is a general increase in prices and a fall in the purchasing value of money. This
happens majorly due to demand for goods and services that exceeds their supply or when there is
too much money in circulation that exceeds the available goods and services in a country, among
other factors].

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Managed float exchange rate system
It is the exchange rate system that lies somewhere between fixed exchange rate system and freely
floating exchange rate system. It resembles the freely floating exchange rate system in that
exchange rates are allowed to fluctuate on a daily basis and there are no official boundaries. It is
similar to the fixed exchange rate system in that governments can and sometimes do intervene to
prevent their currencies from moving too far in a certain direction. This type of system is known
as a managed float or “dirty” float (as opposed to a “clean” float where rates float freely without
government intervention).
Criticism of a managed float system.
The main problem of a managed float exchange rate system is whether or not it works. The
interventions at the time of the Louvre Accord were not found to be statistically significant.
Economic fundamentals, that is the view that the dollar economy was being undervalued, was
probably more responsible for stabilizing the value of the dollar. At best it seems a very weak
form of control of variable rate systems that achieves little.
[The louvre Accord (formally, the statement of the G6 Finance Ministers and Central Bank
Governors) was an agreement, signed on February 22, 1987, in Paris, that aimed to stabilize
international currency markets and halt the continued decline of the US dollar after 1985
following the Plaza Accord. The G6 were Canada, France, West Germany, Japan, UK and US].
Pegged exchange rate system.
Some countries use a pegged exchange rate system, in which their home currency’s value is
pegged to a foreign currency or a basket of foreign currencies. This results in a stable exchange
rate policy between the two countries. While the home currency’s value is fixed in terms of the
foreign currency to which it is pegged, it moves in line with that currency against other
currencies. Some Asian countries such as Malaysia and Thailand had pegged their currency’s
value to the dollar. During the Asian crisis, they were unable to maintain the peg and allowed
their currencies to float against the dollar. Another example of pegged exchange rate system was
that of the Chinese yuan against the U.S, Dollar. It was fixed at yuan 8.28 to $1 from 1994 to
2005, after which the Chinese Government allowed the yuan to appreciate by 2.1%. After this, it
was repegged against a basket of other currencies.
China is known for its huge exports to other countries including America hence by maintaining a
fixed peg of the yuan against the U.S. Dollar China, keeps the price of exports to America
low/cheap. However, this led to U.S. accusing China of currency manipulation.

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Currency board exchange rate system.
A legislated commitment to exchange domestic currency for a specific foreign currency at a
fixed exchange rate. The currency board arrangement commits the government to hold foreign
currency reserves equal to its domestic currency supply. The board must maintain currency
reserves of the specified currency for all the local currency that it has issued. In one sense it may
appear that the currency value is safe in that the currency board can replace the currency it has
issued with foreign currency.
A currency board can stabilize a currency’s value. This is important because investors generally
avoid investing in a country if they expect that the local currency will weaken substantially. If a
currency board is expected to remain in place for a long period, it may reduce fears that the local
currency will weaken and thus may encourage investors to maintain their investments within the
country. However, a currency board is worth considering only if the government can convince
investors that the exchange rate will be maintained.
Example
Hong Kong has tied the value of its currency (the Hong Kong dollar) to the US dollar at
(HK$7.80 = $1) since 1983. Every Hong Kong dollar in circulation is backed by a US dollar in
reserve.
Example
When Indonesia was experiencing financial problems during the 1997-98 crisis, businesses and
investors sold the local currency (rupiah) because of expectations that it would weaken further.
Such actions perpetuated the weakness, as the exchange of rupiah for other currencies placed
more downward pressure on the value of the rupiah. Indonesia considered implementing a
currency board to stabilize its currency and discourage the flow of funds out of the country.
Businesses and investors had no confidence in the Indonesian government’s ability to maintain a
fixed exchange rate against a pegged foreign currency and feared that economic pressures would
ultimately lead to a decline in the rupiah’s value. Thus, Indonesia’s government did not
implement a currency board.
A currency board is effective only if investors believe that it will last. If investors expect that
market forces will prevent a government from maintaining the local currency’s fixed exchange
rate against a pegged foreign currency, they will attempt to move their funds to other countries
where they expect the local currency to be stronger.
Freely floating exchange rate system
In a freely floating exchange rate system, exchange rate values are determined by market forces
of supply and demand of foreign currencies, among other factors without intervention by
governments.
Whereas a fixed exchange rate system allows no flexibility for exchange rate movements, a
freely floating exchange rate system allows complete flexibility. A freely floating exchange rate
adjusts on a continuous basis in response to demand and supply conditions for that currency.

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Examples of countries following this approach are the United States, Mexico, Japan, South
Africa, Switzerland, Canada, India, the United Kingdom, Kenya, among others.
Its Advantages.
A freely floating exchange rate adjusts on a continuous basis in response to demand and supply
conditions for that currency, therefore fostering free international trade.
In a freely floating exchange rate system, a country is more insulated from the inflation of other
countries (see example 1 below).
In a freely floating exchange rate system, a country is more insulated from unemployment
problems in other countries (see example 2 below).
Under a freely floating exchange rate system, the central bank is not required to constantly
maintain exchange rates within specified boundaries. It can therefore hold lower levels of foreign
exchange reserves than would be needed under a fixed exchange rate regime to meet surplus
demand for foreign currency at the fixed rate. Furthermore, governments can implement
monetary policies without concern as to whether the policies will maintain the exchange rates
within specified boundaries.
A further advantage is in stabilizing the Balance of Payments (BOP). The balance of payments
(BOP) is a record of a country’s transactions with the rest of the world. Any imbalance
(disequilibrium) in the balance of payments would be automatically corrected by a change in the
exchange rate. For example, if a country suffers from a total deficit in the balance of payments
(balance of payments deficit means a country imports more goods, capital and services than it
exports), then, other things being equal, the country’s currency should depreciate. This would
make the country’s exports cheaper, thus increasing demand for exports, while at the same time
making imports expensive and therefore decreasing demand for imports. The balance of
payments equilibrium would therefore be restored.
Example 1
Assume there is international trade taking place between the United States and the United
Kingdom and the two countries have adopted a freely floating exchange rate system. If the
United States experiences a high rate of inflation than the United Kingdom, US consumers
should buy more goods from the United Kingdom and British consumers should reduce their
imports of US goods (due to the high US prices). The increased US demand for British goods
will place upward pressure on the value of the British pound (US consumers will need more
British pounds to pay for the goods they are importing from UK). A second consequence of the
high US inflation is that the reduced British demand for US goods will result in a reduced supply
of British pounds for sale in the US to be exchanged for dollars (UK residents are not importing
goods from US hence no British pounds are being paid into the US), which will also place
upward pressure on the British pound’s value (the demand for British pounds by the US
customers exceeds the supply hence the value of the British pound will increase). The British
pound will appreciate due to these market forces (it was not allowed to appreciate under the fixed

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exchange rate system) because a freely floating exchange rate system has been adopted by the
two countries. This appreciation will make British goods more expensive for US consumers,
even though British producers did not raise their prices. The higher prices will simply be due to
the pound’s appreciation; that is, a greater number of US dollars are required to buy the same
number of pounds than before. In the UK, the actual price of the goods as measured in British
pounds remains unchanged, hence, the high inflation of US has not been exported to the UK.
Example 2.
Assume there is international trade taking place between the United States and the United
Kingdom and the two countries have adopted a freely floating exchange rate system. If the
United States experiences a high rate of inflation than the United Kingdom, US consumers
should buy more goods from the United Kingdom and British consumers should reduce their
imports of US goods (due to the high US prices). This reaction would force US production down
and unemployment up, hence, a reduction in US personal income.
Under a floating exchange rate system, the decline in US purchases of British goods, caused by
US unemployment, will reflect a reduced US demand for British pounds. Such a shift in demand
can cause the pound to depreciate against the dollar (under the fixed exchange rate system, the
pound would not be allowed to depreciate). The depreciation of the pound will make British
goods look cheaper further to US consumers, therefore offsetting the possible earlier reduction in
demand for UK goods resulting from a lower level of US personal income due to unemployment.
As was true with inflation, a sudden change in unemployment will have less influence on a
foreign country under the floating exchange rate system than under a fixed exchange rate system.
NB: As the above examples illustrates, in a freely floating exchange rate system, problems
experienced in one country will not necessarily be contagious. The exchange rate adjustments
serve as a form of protection against “exporting” economic problems to other countries.
Its Disadvantages.
In the previous example, the United Kingdom was somewhat insulated from the problems
experienced in the United States due to the freely floating exchange rate system. Although this is
an advantage for the country that is protected (the UK), it can be a disadvantage for the country
that initially experienced the economic problems (the U.S. The U.S. consumers suffered from the
appreciation of the British pound and secondly, the U.S. residents suffered from unemployment
problem).
A further disadvantage is uncertainty. The very fact that currencies change in value from day to
day creates a lot of uncertainty in international trade. A seller may not be quite sure of how much
money he/she will receive after selling goods abroad on credit.

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Exchange rate system with no separate legal tender

One country adopts the currency of another country, or a group of countries adopt a common
currency. An example of the first is the U.S. dollar’s use as legal tender in EI Salvador (A
country in Central America), Panama (A country in Central America), and Ecuador (A country in
Northwestern South America). An example of the second is the European Union’s euro being
used as a common currency in 17 EU member countries. (Legal tender are coins or bank notes
that are accepted in paying for transactions).