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Exchange Rates and Exchange Rate System

The exchange rate is the rate of exchange that indicates the price, i.e. the external value of a country’s currency. For example, USD1 = INR67 means that 1 US dollar is exchanged for 74 Indian rupees to meet foreign obligations.

The foreign exchange market is an institutional arrangement for buying and selling foreign currencies. Exporters and importers respectively sell and buy foreign currencies. In international payments, one country’s currency is converted into another country’s currency through the foreign exchange market.


Exchange Rate System

There are three types of exchange rate systems

  1. Fixed exchange rate
  2. Flexible exchange rate
  3. Managed exchange rate

Fixed Exchange Rate System

A fixed exchange rate is determined by the Government or Monetary Authorities. A fixed-rate was introduced under the Bretton Woods System in the form of the gold exchange standard or US dollar standard.

IMF members were asked to declare the par value of their currencies vis-a-vis gold and, in turn, the US dollar. The fixed exchange rate was not allowed to change by more than ±1% unless permitted by the IMF.

In a fixed exchange rate system, a country officially fixes a specific exchange rate for its currency in terms of a given foreign currency and maintains it over a period of time.

Advantages of Fixed Exchange Rate

Advantages of Fixed Exchange Rate are:

  1. Element of certainty
  2. Foreign capital
  3. International investments
  4. Speculative activities
  5. Added incentives
  6. Multilateral trade
  7. Monetary system
  8. Economic traffic
  9. Economic stabilization
  10. Prosperity and growth

Drawbacks of Fixed Exchange Rate

Drawbacks of Fixed Exchange Rate are

  1. Permits of IMF
  2. Not permanent
  3. Not adjustable
  4. Rare coordination
  5. Other difficulties include
  • Fails to consider changes in the external value of foreign currencies
  • Difficult to establish acceptance criteria for devaluation
  • Does not measure equilibrium in the balance of payments (BOP) positions

Example of Fixed Exchange Rate

1. Africa has the most (19) countries with fixed currencies

14 countries including Chad, Benin, Central African Republic, Cuba, and Niger, use the CFA franc that is pegged to the Euro and 3 countries including Namibia, Lesotho, and Swaziland, are pegged to the South African Rand (ZAR) as part of a Common Monetary Area

2. The Middle East

The Middle East has 7 countries that are all pegged to the USD, including Bahrain, Saudi  Arabia, UAE, Qatar, Oman, and Lebanon.

3. Nepal

Nepal is the only country pegged to the Indian rupee. Given the INR’s volatile state, Nepal may break away from this peg.

Flexible Exchange Rate

A flexible exchange rate is freely determined by the interaction between the demand for and supply of foreign exchange in the foreign exchange market.

There are two well-known types of flexible exchange rates:

1. Floating exchange rate

Refers to the exchange rate determined by the market

2. Managed flexible exchange rate

Refers to advanced countries that gave up the dollar exchange rate and allowed market forces to determine the rate

In a flexible exchange rate system, exchange rates are allowed to float with changing conditions, and the relative positions of demand and supply of foreign exchange depend on deficit or surplus in a country’s BOP.

Arguments for Flexible Exchange Rate

Arguments for Flexible Exchange Rates are

  1. Adjusts BOP
  2. Provides monetary autonomy
  3. Economic stability
  4. Domestic economies operate independently
  5. Private speculation
  6. Adjustment to equilibrium
  7. Full employment
  8. Continuous effect
  9. Natural level
  10. International liquidity

Arguments against Flexible Exchange Rates

Arguments against Flexible Exchange Rates are

  1. Creates uncertainty
  2. Discourages investments
  3. Causes unemployment
  4. Lacks stability
  5. Poor cooperation
  6. Inflationary bias
  7. Unstable nature

Managed Flexible Exchange Rate

  • The managed flexible exchange rate is managed with a floating system through government intervention to bring required stability in the foreign exchange market.
  • Exchange market intervention refers to the sale or purchase of foreign currency by monetary authorities to change the exchange rate of their own currency vis-a-vis one or more currencies.
  • Most developing countries used flexible exchange rates under the IMF until 1973; subsequently, like developed countries, they gave up the dollar exchange rate and allowed market forces to determine the exchange rate.
  • In developing countries with thin and narrow foreign exchange markets, a central bank’s ‘leaning against the wind’ intervention policy aims to check erratic fluctuations in the exchange rate of its currency.

Government Intervention in Flexible Exchange Rate

The Government intervenes to manage the exchange rate for the following reasons

1. To produce a more appropriate rate

The Government or Monetary Authorities can better collect relevant information and predict the future course of policies and their implications for a reliable exchange rate.

2. To mitigate costs of real exchange rates

Disturbances in economic activities caused by changes in the exchange rate can be controlled if the Government or Monetary Authorities intervene and produce necessary changes in the exchange rate.

3. To smoothen economic adjustments

Government intervention can reduce disturbances and effects of a persistent surplus or deficit in the BOP.

Foreign Exchange Instruments

1. Foreign Bill of Exchange

A written request or order from the drawer (exporter-creditor) to the drawee (importer-debtor) to pay a certain sum of money either to himself or to the payee as ordered by demand.

2. Bank Draft

A bank orders its branch or another bank to pay the bearer (exporter-creditor), on-demand, a specified amount out of its deposit account from the concerned country.

3. Telegraphic Transfer

A telegraphic order from a bank to its correspondent bank abroad to pay a certain sum of money to a certain person out of its deposit account.

4. Letter of Credit

An instrument authorizing a person to draw a bill or cheque for a specified sum on the issuing bank at a stimulated time for the liability of payment.

5. Traveller’s Cheques

Cheques issued by a bank for a specific amount can be cashed at a branch or correspondent of the bank in a foreign country.

Participants in the Foreign Exchange Market

Participants in the Foreign Exchange Market are

1. Central Banks

Central banks represent the Government’s highest monetary authority and influence policies and intervene in the dealings of the foreign exchange market.

2. Commercial Banks

Many international transactions are handled by commercial banks, through crediting and debiting of different customer accounts to meet their financial dealings.

3. Non-Banking Financial Institutions (NBFCs)

Many asset-management companies and general insurance companies offer financial instruments to deal in various countries and currencies.

4. Multi-National Corporations (MNCs)

MNCs operating in multiple countries need to make or receive payments in different countries.

5. Foreign Exchange Brokers

Foreign exchange brokers are agents facilitating trade between importers and exporters on a commission basis toward their client’s country.

6. International Retail Clients

Many individuals, international investors such as MNC-owners, and institutional-founders deal in the foreign exchange market through bank agents.

7. Tourists and Dealers

Tourists also need to use the foreign exchange market to avoid foreign risks.

Functions of the Foreign Exchange Market are

  1. Transfer of purchasing power from one country to another
  2. Provision of credit for foreign trade at national and international levels
  3. Provision of facilities to hedge foreign exchange risks and uncertainties
  4. Arbitrage activities conducted by required individuals in foreign money
  5. Speculation function conducted by speculators of foreign money in different countries to earn the profit.