There are three broad exchange rate systems :

  • currency board,
  • fixed exchange rate and
  • floating rate exchange rate.

A fourth can be added when a country does not have its own currency and merely adopts another country‘s currency.

The fixed exchange rate has three variants and the floating exchange rate has two variants. This consists of

  1. rigid peg with a horizontal band,
  2. crawling peg and
  3. crawling band.

Variants of a Fixed Exchange Rate System

1. Rigid Peg with a Horizontal Band

It is an exchange rate system under which the exchange rate fluctuation is maintained by the central bank within a range that may be specified (Iceland) or not specified (Croatia). The specified band may be one- sided (+7% in Vietnam), a narrow range (+ 2.25% in Denmark) or a broad range (+ 77.5% in Libya).

2. Crawling Peg

The par value of the domestic currency is set with reference to a selected foreign currency (or precious metal or currency basket) and is reset at intervals, according to pre-set criteria such as change in inflation rate. The central bank decides the new par value based on the average exchange rate over the previous few weeks or months in the foreign exchange market. The biggest advantage of the crawling peg is its responsiveness to the market value of the domestic currency.

3. Crawling Band

The domestic currency is on a crawling peg which is maintained within a range (band).

Floating Exchange Rate

This consists of

  1. managed float and
  2. free float.

When a country has its own currency as legal tender, it can choose between the three broad types of exchange rate systems. Within the fixed exchange rate, a country can choose a rigid peg or a crawling peg. Again within each peg, it can choose to have a horizontal band within which its exchange rate would be permitted to fluctuate. Within the floating exchange rate system, a country can choose a free float or a managed float. The main source of the exchange rate system followed by any country is the IMF‘s Annual Report on exchange rate arrangements. Many countries declare that they follow a particular exchange rate system, but may follow another system in practice:

1. Exchange Arrangements with No Separate Legal Tender

A few countries (such as Micronesia and San Marino) select another country‘s currency as legal tender. This is called Dollarization, since the selected foreign currency is usually the US dollar.

2. Currency Board

The central bank of the country promises to convert domestic currency (on demand and at any point in time) for a predetermined number of units of a specific foreign currency. In order to fulfill this promise, the central bank has to hold foreign exchange reserves in the selected foreign currency. Usually a government decides to adopt a currency board when the holders of domestic currency lose confidence in it is as a medium of exchange, triggered by rampant inflation, unbridled government debt (resulting in fiscal deficits) and recession.

The first currency board was set up in Mauritius in 1849. Hong Kong has had a currency board since 1983 when its currency was linked to the US dollar. Argentina chose the currency board in 1991 and Bosnia in 1997. Argentina‘s currency board promised to convert each peso into one US dollar. The Central Bank held only 66% of the peso as dollar reserves, when it should have held 100% (given the 1:1 peso/dollar currency board arrangement). In 2001, Argentina defaulted in repayment of its external debt and confidence in the Argentine peso plunged. There was a run on the banking system, and the government abandoned the currency board.

Variants of a Floating Exchange Rate System

1. Managed Float

A floating exchange rate (or exchange rate) is the opposite of the fixed exchange rate. Market forces determine the value of the domestic currency against a selected foreign currency. A managed float (or dirty float) is a floating exchange rate in which the monetary authorities influence the exchange rate (through direct or indirect intervention without specifying the target exchange rate. India is on a managed float.

2. Free Float or Clean Float Managed Float

Here, the exchange rate is purely determined by market forces (demand and supply of the currency).

Advantages of Flexible Exchange Rate System

  1. It permits quicker adjustments in the exchange rate to changes in macro-economic factors such as changes in inflation rate, growth rate, and interest rates.
  2. There is less likelihood of currency So the country‘s growth prospects are brighter.

Disadvantages of Flexible Exchange Rate System

  1. Exchange rate risk is high due to greater volatility in the short- and long-term. This makes exchange rate forecasting extremely important as well as extremely difficult.
  2. There is a tendency for capital inflows through foreign portfolio investment, or ‗hot money‘.
  3. Imports and overseas debt repayment are adversely affected by depreciation of domestic currency.

Determination of Floating Exchange Rates

There are four theories that explain how floating exchange rates are set. The first theory (the demand and supply theory) is called a flow theory because it studies how the demand for and supply of a domestic currency over a period of time results in a particular level for the exchange rate. The other three theories (the monetary theory, the asset price theory, and the portfolio balance theory) are called stock theories, since they study the amount of currency available at a certain time-the stock of currency-and peoples‘ willingness to hold the currency. They are also called modern theories of exchange rate determination.

Fixed Exchange Rate

It is also called the pegged exchange rate. The par value of the domestic currency is set with reference to a selected foreign currency (or precious metal or currency basket). The exchange rate fluctuates with a range (usually +1% of the par value).

The domestic currency‘s par value is fixed by the monetary authorities against any of the following:

  • A precious metal (gold in the gold standard)
  • A single currency, which can be an artificial currency (such as the SDR), or an existing currency (such as the US dollar or the pound sterling). When a single currency is chosen, in some cases colonial legacy determines the choice-most former French colonies chose the French franc, while former British colonies tended to choose the pound sterling. Sometimes, a fixed exchange rate is adapted to arrest the steep fall in value of the domestic currency. In September 1998, the Malaysian monetary authorities announced a rigid peg of 3.8 ringgit/USD after the Ringgit plunged by 60% against the US dollar.
  • A currency basket as in the case of the Indian rupee in 1975; the Indian rupee was de-linked from the pound and linked to a basket of currencies. The central bank may keep the currencies in the basket a secret, or make the currency In 2005, China pegged its yuan to a currency basket whose composition and weights are undisclosed.

Advantages of Fixed Exchange Rate System

  1. There is stability in exchange rate and exchange rate risk is nil.
  2. Capital inflows through foreign direct investment are higher because there is no exchange rate FDI is a ‗desirable‘ capital inflow due to its stable and long- term nature.
  3. Inflation rates tend to be lower and therefore real interest rates (nominal interest rates adjusted for inflation) are higher.

Disadvantages of Fixed Exchange Rate System

  1. The exchange rate does not reflect macro-economic The entire foreign exchange entering and leaving the country has to be converted at the fixed exchange rate.
  2. Punitive action for contravening rules.

In a fixed exchange rate regime, the entire institutional infrastructure is geared towards identifying evasion of foreign exchange controls and imposing penal punishments. A fixed exchange rate creates a flourishing parallel market for foreign exchange in which the ‗true‘ value of the domestic currency is determined by market forces. This is because the par value of the domestic currency is very often at variance with what the exchange rate would be if left to the vagaries of supply and demand.

Very often countries fix a separate par value for exports and a separate one for imports. This is done to boost its exports and deter imports. This merely increase the draconian system needed to monitor foreign currency inflows and outflows.

The problems with a fixed exchange rate are described below

  1. The possibility of overvaluation of the domestic currency is quite high. Suppose the rupee is on a fixed exchange rate of Rs. 40/$ instead of Rs. 43/$ when left to market forces. So, instead of 1$ being able to buy 43 worth of goods, it can buy only Rs. 40 worth of goods). This would hurt the competitiveness of India‘s exports and therefore hamper its growth prospects.
  2. When the country on a fixed exchange rate is seen consistently to have trade surpluses, it generates a lot of ill will, and a perception that the trade surpluses are the result of currency manipulation of keeping the exchange rate artificially high (or low as the case may be). Consider the hypothetical example below. If the Chinese yuan should have an exchange rate of yuan 5.60/$ but is instead kept at yuan 7.00/$, Chinese exports have extremely competitive prices in world markets, and China has a trade surplus.

De Facto and De Jure Exchange Rate Systems

A de facto exchange rate is the one that a country actually follows. A de jure exchange rate system is the one that the country claims to follow. Both systems need not always be the same. China‘s de facto system was the fixed rate but it insisted that its de jure system was a managed float. The IMF conducts surveys of exchange rate systems around the world. The surveys take into account both the de facto and de jure systems for each country.