How Did Fixed And Floating Exchange Rate Systems Evolve?

How Did Fixed And Floating Exchange Rate Systems Evolve?

07 Nov 2019 10:48 AM

In financial markets, a foreign exchange rate is the rate at which one currency is converted into another currency. The price of any product is ideally determined by supply and demand which is dependent on various factors like economic policies, political stability, economic data, trade relations with other economies, market sentiments, technical factors, etc. Thus a government can either let the economies play role and market forces determine the rate of conversion or the government can fix a rate. These are categorized as fixed or floating foreign exchange rates.

Foreign exchange rate system evolution

Much before foreign exchange markets came into existence, the gold standard was the norm, wherein a country ties the value of its money to the amount of gold it possesses. So a fixed asset backs the value of the money so the government could print as much money as the gold the country has. This kept the inflation in check. The US ended the Gold standard in 1971 as countries which didn’t have any gold were at a competitive disadvantage. The economy is not valuing the resourcefulness of its people and businesses.

In 1944, Bretton Woods agreement established a new global monetary system. The gold standard was replaced with a global currency – US Dollar as US had 75% of world’s supply of gold. Under this agreement, the central banks of member countries would maintain a fixed exchange rate between their currencies and the dollar. The value of dollar began to increase relative to other currencies and so did the demand for the dollar increased even though the worth in gold remained the same. This led to the collapse of the Bretton Woods fixed exchange rate system after three decades.

In 1971, the US President Richard Nixon temporarily suspended dollar’s convertibility to gold after which an attempt to revive the fixed exchange rates failed, so by March 1973, the major currencies started floating against each other. Each member agreed to redeem its currency for US Dollar not gold. Thus the modern foreign exchange market started its shift from a fixed exchange rate to a floating exchange rate system. Thus a global decentralized, over the counter (OTC) market for trading of currencies evolved which determines the forex rates for each currency.

Fixed v/s Floating exchange rate

When the rate of exchange is officially fixed by the government or the monetary authority it is a fixed exchange rate. Here the rate is not left to the market forces. For example, China sets a middle rate for its currency within which is moves to avoid any sudden unrealistic movement of forex rates. A small deviation from this middle value is permitted. Under the Gold standard, the countries were to convert its currency into gold at a fixed price.

Thus exchange rate was fixed according to the gold value of currencies that have to be exchanged, called as the mint par value of exchange. Later on a fixed exchange rate system came to being under an agreement in July 1994.

Crawling Peg - It is seen as part of fixed exchange rate regime as appreciation or depreciation in a currency can happen in a gradual manner. Thus it moves in a band of rates which may be adjusted frequently especially in times of high volatility. Thus economic fundamental lets the market determine the change in exchange rate within permissible narrow band. Some countries use crawling peg to address inflation during currency crisis.

Adjustable Peg – In order to improve export competitiveness, the country fixes or pegs its currency to a major currency like US Dollar or Euro but when the market conditions change, the same can be readjusted. Usually the peg has 2% flexibility against a certain level. This was the basis of Bretton Woods system.

Few advantages of a fixed exchange rate system are that

  1. It ensures stability of rate which in turn gives confidence for foreign trade
  2. Thus any major economic disturbance is avoided
  3. As confidence is built, it prevents capital outflow
  4. Thus avoiding risk and uncertainty in forex transaction
  5. Speculation is also prevented

Few demerits are

  1. Devaluation fear – this is with rising demand as the supply taps the foreign exchange reserves in order to maintain the foreign exchange rate.
  2. This leads to under or over valuation and
  3. Thus free market benefits are deprived.

A floating exchange rate system is one where the exchange rate is determined by the foreign exchange market forces of demand and supply of foreign exchange. It’s also called as the flexible exchange rate system. The currency value freely adjusts or changes as per prevailing market sentiments and conditions.

The central banks do not officially intervene in the market but recent developments have led to naming certain economies as currency manipulator thus questioning the flexibility of the rate.

Merits of a flexible exchange rate system are

  1. The necessity of holding forex reserves becomes redundant
  2. Thus freeing the government from balance of payment problems – it automatically corrects any deficit or surplus
  3. Aids in optimally allocating resources

Demerits of floating exchange system are

  1. During uncertain times, the high fluctuation hampers foreign trade and investments
  2. Generates inflationary pressure when home currency depreciates.
  3. Encourages speculation when volatility is high.

To avoid the demerits, few economies manage the floating exchange rate to save its currency from short term volatility which is due to speculation or economic shocks. But when other economies have a disadvantage when manipulating the currency, it become unethical and is called as dirty floating. If the intervention is within set rules and guidelines, then it’s a fair intervention.

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