Question

What is an exchange rate system? What is the difference between a fixed exchange rate system and a managed float exchange rate system?

Short answer

An exchange rate system is the method a monetary authority uses to manage its currency in relation to other currencies and the foreign exchange market. A fixed exchange rate system maintains a certain exchange rate through direct intervention by the monetary authority. A managed float exchange rate system allows the exchange rate to fluctuate due to market forces, but the monetary authority may intervene to prevent sharp or disruptive changes.

Step-by-step solution

Explain Exchange Rate System

An exchange rate system, or regime, is the way a monetary authority of a country manages its currency with respect to other currencies and the foreign exchange market.

Define Fixed Exchange Rate System

In a fixed exchange rate system, the government or central bank maintains the exchange rate of its currency at a certain level or within a range against another currency, often by buying or selling its own currency on the open market.

Define Managed Float Exchange Rate System

In a managed float exchange rate system, also known as a 'dirty float', a country's exchange rate is normally allowed to fluctuate according to market forces and the central bank will only intervene to prevent sharp changes and to maintain stability.

Differences Between Fixed and Managed Float Exchange Rate Systems

In a fixed exchange rate, the rate is set and maintained by the government and does not fluctuate day-to-day. In contrast, in a managed float system, although the rate is generally free to fluctuate, the government or central bank may intervene to stabilize the market if it considers the currency's value is moving too sharply or disruptively.

Key concepts

Fixed Exchange Rate System

In a fixed exchange rate system, a country's central bank or government sets the value of its currency relative to another currency or a basket of currencies. This rate does not fluctuate from day to day, providing more stability in international trade and investment. The central bank accomplishes this by:

• Maintaining reserves of foreign currencies
• Intervening in the foreign exchange market to buy or sell its own currency
• Setting interest rates to influence economic activities that affect currency value

For example, if a country like Hong Kong wants to peg its currency to the US dollar, it will ensure that the exchange rate between the Hong Kong dollar and the US dollar remains constant, often at a predetermined rate. This approach can help in removing exchange rate risk for traders and investors.
However, to sustain a fixed exchange rate, a country must have substantial foreign currency reserves and the ability to control economic factors, such as inflation and interest rates. Any deviation calls for corrective measures such as adjusting monetary policies or directly intervening in the currency markets. If the pegged currency becomes too weak or strong, it can lead to economic imbalances, requiring continuous adjustments.

Managed Float Exchange Rate System

A managed float exchange rate system allows the value of a currency to be determined by market forces while still leaving room for government intervention. Often referred to as a 'dirty float,' this system provides a middle ground between fixed exchange rate regimes and purely floating rates. In managed float systems, central banks monitor exchange rates closely. They intervene by:

• Buying or selling foreign currencies
• Adjusting levels of domestic interest rates

The goal of these interventions is to prevent excessive volatility that could disrupt economic stability. Central banks may not act routinely. Instead, they step in during extreme fluctuations, ensuring that the exchange rate doesn’t deviate drastically from what they believe is a fair value.
Countries like India often use managed float systems. This approach allows their currencies to adapt gradually to changing economic conditions, while also giving policymakers the flexibility to combat any adverse effects from rapid movements in currency values. It essentially provides a balance between allowing the market to play its role and maintaining economic stability through timely interventions.

Foreign Exchange Market

The foreign exchange market, often abbreviated as Forex or FX, is the global platform where currencies are traded. It is the largest financial market in the world and operates 24 hours a day due to its ability to function across different time zones. Here, exchange rates are determined by supply and demand dynamics, influenced by various factors such as:

• Interest rates
• Inflation rates
• Political stability
• Economic performance indicators

The foreign exchange market is crucial for facilitating international trade and investment. It allows businesses to convert their profits back into their home currency. It also provides a means for hedging against currency risk.
Participants in the Forex market include central banks, commercial and investment banks, corporations, hedge funds, and retail investors. While central banks might aim to manage or stabilize their currency values, other participants often engage in trades to realize profits from currency value fluctuations.
These trades and currency exchanges can be speculative or based on actual need, like acquiring a foreign currency to pay for goods and services or to undertake international financial transactions.