Exchange Rate System

Exchange rates system play a crucial role in the global economy, influencing trade, investment, inflation, and the overall economic well-being of nations. In the context of competitive examinations like the Union Public Service Commission (UPSC), having a comprehensive grasp of exchange rate system is indispensable for candidates aspiring to understand and analyze global economic dynamics.

Meaning of Exchange Rate

An exchange rate is like a price tag showing how much of one currency you can get in exchange for another. It tells you the value of your money in terms of a different currency. This value changes depending on factors like how much demand there is for each currency, interest rates, inflation, and global events.

The exchange rate between two currencies is typically influenced by factors such as economic activity, market interest rates, gross domestic product, and unemployment rates in each respective country. Banks and financial institutions continuously trade currencies in the global financial market, establishing what is known as market exchange rates, considering these variables. Exchange rates can fluctuate regularly, either gradually or in significant increments, sometimes changing by small margins within hours or days.

Exchange rates can fall into one of two categories: fixed or floating. Fixed exchange rates are determined by a country’s central banks, while floating exchange rates are determined by market demand and supply dynamics.

Types of Exchange Rate System

Fixed Exchange Rate system:

In a fixed exchange rate system, the government sets and maintains the value of its currency in relation to another currency or a standard like gold. The goal is to ensure stability in international trade and capital flows. To achieve this, the government intervenes by buying foreign currency when the value of its currency rises and selling it when it falls. This requires holding significant reserves of foreign currencies. This system is also known as the Pegged Exchange Rate System, where one currency’s value is tied to another. In earlier times, there were two main methods:

1. Gold Standard System (1870-1914): Countries defined the value of their currencies in terms of gold. For instance, if 1 UK Pound was equal to 5 grams of gold and 1 US Dollar was equal to 2 grams of gold, then the exchange rate would be £1 (UK Pound) = $2.5 (US Dollar).
2. Bretton Woods System (1944-1971): Countries fixed their currencies against the US Dollar, which was pegged to gold. This system allowed for some adjustments and was managed by the International Monetary Fund (IMF). It was eventually replaced by the Flexible Exchange Rate system in 1971.

Merits of fixed exchange rate:

1. Merits of Fixed Exchange Rate System:
2. Ensures stability in exchange rates, facilitating foreign trade.
3. Helps government control inflation.
4. Prevents speculation in the foreign exchange market.
5. Promotes domestic capital movements by eliminating uncertainties about foreign rates.
6. Prevents capital outflow.

Demerits of Fixed Exchange Rate System:

1. Requires substantial reserves of gold, restricting capital movement.
2. May lead to currency undervaluation or overvaluation.
3. Discourages free market principles.
4. Challenges in addressing economic downturns like depression or recession.

Flexible Exchange Rate System:

In the Flexible Exchange Rate system, the forces of supply and demand in the foreign exchange market solely determine currency values, hence its alternative names: Floating Rate of Exchange or Free Exchange Rate. Unlike fixed exchange rate systems, there is no government intervention in this system. Exchange rates fluctuate according to market dynamics, determined by the interactions among banks, firms, and other entities trading foreign exchange.

Merits of Flexible Exchange Rate System:

1. No need for government reserves.
2. Eliminates currency overvaluation or undervaluation issues.
3. Encourages foreign venture capital.
4. Enhances resource allocation efficiency.

Demerits of Flexible Exchange Rate System:

1. Encourages speculation.
2. Lack of stability due to fluctuating exchange rates.
3. Coordination of macro policies becomes challenging.
4. Uncertainty discourages international trade.

What is managed floating?

The Managed Floating Exchange Rate system is a blend of both fixed and flexible exchange rate systems, earning it the moniker “Hybrid System.” In this approach, market forces primarily determine the foreign exchange rate, but the central bank intervenes to stabilize the rate if the domestic currency experiences significant appreciation or depreciation.

Under this system, the central bank plays a role in regulating the exchange rate by buying or selling foreign exchange reserves. When the exchange rate rises, the central bank sells foreign exchange to lower it, and conversely, it buys foreign exchange to raise the rate. This intervention aims to safeguard the interests of importers and exporters.

To execute this strategy, the central bank maintains reserves of foreign exchange to ensure the exchange rate remains within a targeted range. If a country manipulates the exchange rate without adhering to regulations, it is termed as “Dirty Floating.” When the central bank adheres to prescribed rules and regulations to influence the exchange rate, it constitutes a managed floating approach

Also read about Balance of Payment from here.

Nominal vs Real Exchange Rate

Real Effective Exchange Rate vs Nominal Effective Exchange Rate

Appreciation and Depreciation of Currency

The Appreciation and depreciation of a currency denote alterations in its value relative to another currency within a freely floating exchange rate system. Appreciation signifies an increase in a currency’s value compared to another, while Depreciation indicates a decrease. In such systems, the interplay of supply and demand forces in the exchange markets determines currency values.

Impact of depreciation of currency

• Export Competitiveness: A devalued currency enhances a nation’s export competitiveness, potentially elevating export volumes and enhancing trade balance by making exports more affordable in global markets.
• Expensive Import : Currency depreciation raises the cost of imported goods, reducing purchasing power and potentially fueling inflation while affecting the affordability of imported items.
• Current Account Balance: Currency devaluation can positively impact a country’s current account balance by curbing imports and stimulating exports, thus favorably influencing the overall balance of payments.
• Foreign Debt: Currency depreciation increases the burden of debt repayment for countries with significant foreign debt in foreign currencies, as it requires more domestic currency for the same payments.
• Inflationary tendency: Depreciation can drive inflation by elevating the cost of imported goods and raw materials, impacting consumer purchasing power and overall price levels.
• Tourism and Foreign sector: A devalued currency can attract tourists and foreign investors by increasing their spending power in relation to the depreciated currency, potentially bolstering the tourism and investment sectors.

Impact of appreciation of currency

• Export Reduction: A robust currency increases the price of a country’s exports in global markets, potentially diminishing export competitiveness and reducing export volumes.
• Cheap Import: Appreciation decreases the cost of imported goods, enhancing affordability for domestic consumers. This may lead to reduced inflation and improved consumer purchasing power.
• Current Account Deficit: Currency appreciation can trigger a current account deficit by boosting imports and diminishing exports, potentially impacting the overall Balance of Payments.
• Foreign Investment: A strengthened currency may deter foreign investors due to decreased returns in their own currency, potentially resulting in reduced foreign direct investment (FDI) and capital inflows.
• Tourism Sector: Appreciation can elevate the cost of visiting a country for tourists, potentially affecting the tourism sector and its economic contribution.
• External Debt: Currency appreciation can alleviate the burden of servicing external debt denominated in their own currency for countries, as it requires fewer domestic currency payments.

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