6. Exchange Rate System – Fixed and Flexible Exchange Rate

♤ Flexible Exchange Rate: This is also known as floating exchange rate system. The exchange rate is determined by the forces of market demand and supply. In a flexible system, the central banks do nothing to directly affect the level of the exchange rate. The central banks therefore don’t intervene in the foreign exchange market (and this means there are no official reserve transactions.)

In a fixed exchange-rate system, a country’s central bank typically uses an open market mechanism and is committed at all times to buy and/or sell its currency at a fixed price in order to maintain its pegged ratio and, hence, the stable value of its currency in relation to the reference to which it is pegged.

♤ Fixed Exchange Rates: Countries have had flexible exchange rate system since Bretton woods system collapsed. Previous to that, most countries had the fixed rate system or the pegged exchange rate system (called in some countries only). It must be noted that in a fixed exchange rate system such as the gold standard, adjustment to the BoP surplus or deficits can’t be brought about through changes in exchange rates. Adjustment should

either happen automatically or brought about by the government. In a fixed exchange regime, the government may also devalue the currency. In a fixed exchange rate system, the government may choose to leave the exchange rate unchanged and deal with the BoP problem by the use of monetary and fiscal policy.

♤ Managed Floating: The present day world order has moved to a managed floating exchange rate system. It is a mix of a flexible exchange rate system and a fixed rate system. This is also referred to as Dirty Floating – where central banks intervene to buy and sell foreign currencies in an attempt to moderate exchange rate movements whenever they feel such actions are appropriate. Official reserve transactions are not equal to zero in this case.