The exchange rate system is defined as the policy framework adopted by a country to manage its currency exchange rates. The two main types of systems are fixed exchange rates and free exchange rates, each with several variants.
This term is sometimes referred to as an exchange rate regime.
Characteristics of an ideal exchange rate system
A currency regime must have several characteristics to be considered ideal. First, the exchange rate between two currencies must be established credibly. This is to eliminate uncertainty related to purchasing power on the price of goods and services and real and financial assets.
Second, a currency must be easily converted to another currency. Exchange rate convertibility allows capital flows to move freely across countries.
Third, the currency must allow the monetary authority to undertake an independent monetary policy in pursuing domestic objectives, such as economic growth and inflation targets.
Exchange rate system types
In general, the exchange rate system falls into two categories:
- A fixed exchange rate in which the currency is left unchanged (appreciating or depreciating).
- A floating exchange rate, whereby currencies are floating or moving freely, depends on the foreign exchange market’s supply-demand fundamentals.
In the implementation, you can find many variations of the two systems. It depends on the monetary policy in each country.
For example, some countries implement a managed floating exchange rate system. Under this system, the exchange rate is allowed to move freely; however, when it is too volatile, the government will intervene to smooth it.
In the past, fixed exchange rates also are pegged but adjustable. This means that the government pegs their currency to a certain level, but can move up and down within a fairly tight band of, say, +/- 1%.
Well, let me cover some of the variations in the exchange rate system. The following is the list:
- Gold standard
- Adjustable peg
- Flexible exchange rate (or floating exchange rate)
- Fixed exchange rate
- Crawling Peg
- Currency Board System (CBS)
- Target zone
- Managed floating
- Independently floating rates
In the past, gold became a standard in determining exchange rates. Under this standard, the currency of any country can be converted into gold at a fixed price. In this case, the central bank operates the buying and selling prices. The price difference between the two is only slightly different.
Under the gold standard, the exchange rate between the two currencies cannot move further from par. A move far from par would make it profitable for speculators to buy gold from one central bank and sell it to another for arbitrage profits.
Under the Bretton Woods system, countries pegged the face value of their currency to the US dollar, and at the same time, the value of the US dollar was pegged to gold. So, indirectly, the currencies of non-US countries peg their money to gold.
Individual countries seek to maintain market exchange rates within a small margin of these figures.
The gold standard difference is that countries retain the right to change their par level when there is a disequilibrium. For example, when the US dollar weakens, they revaluate their benchmark.
In this system, the government’s commitment to a current nominal price lacks credibility. Hence, speculators often force countries with weak currencies to devalue their currencies.
Flexible exchange rate
Flexible exchange rates were adopted since 1973, after the collapse of the Bretton Woods Agreement.
Under this system, the exchange rate depends on supply and demand on the forex market. Any market movement can affect and change exchange rates.
The central bank does not peg or control these movements. Hence, flexible exchange rates are free from government intervention.
Fixed exchange rate
Under a fixed exchange rate, the government or central bank binds the exchange rate of the country’s official currency against the currency of another country or the price of gold.
The objective of a fixed exchange rate is to minimize uncertainty due to exchange rate movements.
Under this system, the government tries to smooth exchange rate changes instead of setting fixed targets. Central banks adjust low and periodically their rates, usually in response to changes in selected economic indicators
This system falls into two categories:
- Passive crawling peg, where the exchange rate is often adjusted in line with the inflation rate. This was adopted in Brazil during a period of high inflation. The aim here is to prevent a decline in foreign currency reserves.
- Active crawling peg, where the exchange rates for the coming weeks have been previously announced. The central bank may make changes in small steps. This system was adopted in Uruguay, Argentina, and Chile. The goal here is to manipulate inflation expectations.
Under dollarization system, a country adopts another country’s currency (usually the US dollar) as a medium of exchange and the unit of accounts. In this case, the country inherits the credibility of the currency, such as the US dollar, but not the United States’ creditworthiness.
Because their creditworthiness is different, the interest rates for the two countries will also be different. Interest rates in US dollars in these countries will not be the same as those in the United States, even though both use the US dollar as their currency.
Currency Board System
According to the IMF’s definition, the Currency Board System (CBS) is based on an explicit legislative commitment to exchange domestic currency for certain foreign currencies at a fixed exchange rate.
This system is usually combined with restrictions on the monetary authority in issuing currency. This implies that domestic currencies will only be issued against foreign currencies if they remain fully supported by foreign assets.
In this system, the exchange rate is pegged to the single currency or a basket of currencies of the main trading partners. Monetary authorities are prepared to buy or sell foreign currency reserves to keep the exchange rate in a narrow band.
Despite limited monetary independence, the central bank can act as the lender of last resort. This system’s success depends on the willingness and ability of the monetary authorities to maintain a fixed exchange rate.
Moreover, a certain level of foreign reserves is required to maintain credibility. Otherwise, the currency is vulnerable to speculative attacks and devaluation.
A variation of this system is fixed parity with crawling bands. Initially, the adopting country would set its currency exchange rate to foreign currency but gradually moved towards a more flexible system with a pre-announced widening of the band around central parity. This allows the country more flexibility in determining its monetary policy.
This system is similar to the fixed exchange rate system. Meanwhile, the only difference is that the monetary authority aims to maintain the exchange rate within a slightly wider range. This gives the central bank greater flexibility to undertake discretionary policies.
In this system, the government does not explicitly state its exchange rate target. Despite this, the government continues to intervene in the foreign exchange market to meet its policy objectives.
Such intervention usually also causes the country’s trading partners to retaliate in the same way. As a result, the adoption of this system can lead to instability in the forex market.
Independently floating rates
In this system, the exchange rate moves freely. Exchange rates move freely, depending on the conditions of supply and demand in the market. The central bank does not intervene in determining the exchange rate.
This exchange rate system allows the central bank to engage in independent monetary policy to achieve full employment and price stability.
This system also allows the central bank to act as a lender of last resort to troubled institutions.