Types of Exchange Rate Systems
1) Fixed Exchange Rate System
In a fixed exchange rate system, a country’s currency is tied to another major currency (like the USD) or a basket of currencies. The government or central bank intervenes in the forex market to maintain the currency’s value within a specific band.
Example: The Hong Kong dollar (HKD) is pegged to the US dollar, maintaining a fixed exchange rate of around 7.8 HKD per USD.
Advantages:
- Certainty for international traders and investors.
- Prevents large fluctuations in exchange rates.
Disadvantages:
- Requires large reserves of foreign currency to defend the peg.
- Can lead to speculative attacks if the market perceives the fixed rate as unsustainable.
2) Floating Exchange Rate System:
In a floating exchange rate system, the value of a currency is determined by the forces of supply and demand without direct intervention from the government or central bank.
Example: The United States dollar (USD) and the Euro (EUR) are part of floating exchange rate systems.
Advantages:
- Automatic adjustment of balance of payments imbalances.
- Monetary policy independence.
Disadvantages:
- Volatile exchange rates, making international trade and investment riskier.
- Uncertainty for businesses involved in foreign trade.
3) Managed (Dirty) Float:
A managed float system is a hybrid where the currency is allowed to fluctuate but the central bank intervenes occasionally to stabilize or direct the exchange rate.
Example: The Indian Rupee (INR) operates under a managed float system. The Reserve Bank of India (RBI) intervenes occasionally to curb excessive volatility.
Advantages:
- Combines benefits of both fixed and floating systems.
- Allows some degree of market determination, but also provides stability through interventions.
Disadvantages:
- Unpredictability in intervention policies can create market confusion.
- Requires consistent monitoring of exchange rate movements.
Causes & Consequences of Exchange Rate Fluctuations:
1) Demand and Supply Factors
- Exchange rates fluctuate based on the supply and demand for currencies. Higher demand for a currency increases its value, while an oversupply can decrease its value.
- Example: Increased demand for US goods will increase demand for the USD, causing it to appreciate.
2) Interest Rates
- Higher interest rates attract foreign capital, increasing demand for the country’s currency. Conversely, lower interest rates lead to capital outflows, depreciating the currency.
- Example: When the US Federal Reserve raised interest rates in 2022, the USD appreciated as foreign investors sought higher returns in US markets.
3) Inflation Rates
- Countries with high inflation will see their currency depreciate as the purchasing power erodes, making exports less competitive.
- Example: Persistent high inflation in Turkey has led to a depreciation of the Turkish lira (TRY).
4) Political Stability and Economic Performance
- Political stability and strong economic performance increase investor confidence, leading to currency appreciation.
- Example: During the Brexit referendum in 2016, the uncertainty led to a depreciation of the British Pound (GBP).
5) Speculation
- Traders often buy or sell currencies based on expectations of future movements. If investors believe a currency will depreciate, they will sell it, causing a self-fulfilling prophecy.
- Example: Speculation about the Euro-zone’s economic stability has led to fluctuations in the value of the euro.
Consequences of Exchange Rate Fluctuations:
1) Impact on Exports and Imports
- A currency depreciation makes a country’s exports cheaper and more competitive in international markets, while imports become more expensive.
- Example: After the depreciation of the British Pound post-Brexit, UK exports became cheaper, boosting export revenues.
2) Inflationary Pressures
- A depreciated currency increases the cost of imported goods, leading to imported inflation.
- Example: The depreciation of the Argentine peso has led to significant inflation as the cost of imported goods skyrocketed.
3) Investment Flows
- Currency appreciation attracts foreign investment, while depreciation discourages it. Foreign investors prefer to invest in economies with stable or appreciating currencies.
- Example: Japan’s strong yen during the 1980s led to massive foreign investments in Japanese real estate and stock markets.
4) Debt Repayment
- Countries with significant foreign-denominated debt will find it more difficult to repay when their currency depreciates. The cost of servicing the debt increases as the value of their local currency falls.
- Example: Many developing countries, such as Venezuela, have struggled with repaying dollar-denominated debt after their local currencies depreciated sharply.
Fixed V/s Floating Exchange Rate Systems
Fixed
- As previously discussed, in a fixed exchange rate system, the value of a currency is maintained at a fixed rate against another currency or a basket of currencies. This requires active government intervention through foreign exchange reserves.
- Example: The Chinese yuan was historically pegged to the US dollar, but in recent years, China has adopted a more managed float system.
Floating
- In a floating system, the value of the currency is determined by market forces with little to no intervention from the central bank.
- Example: The USD and EUR operate under a floating exchange rate system.
Evaluation: Which System Is Better?
- No one system is perfect, and the choice of system depends on the specific needs and economic circumstances of the country.
- Fixed exchange rate systems provide stability but can be costly to maintain, while floating systems offer flexibility but come with the risk of volatility.
- Many countries adopt a managed float approach to combine the advantages of both systems.
- Example: The Eurozone combines elements of both systems, with the euro being used as a common currency among member states, while the European Central Bank intervenes periodically to manage inflation and exchange rate stability.
