Question

Rules considered necessary for fixed exchange rate regimes?

Answer 1

There are two basic systems that can be used to determine the exchange rate between one country’s currency and another’s: a floating exchange rate system and a fixed exchange rate system. In a fixed exchange rate system, a country’s government announces what its currency will be worth in terms of something else and also sets up the rules of exchange. These will determine the type of fixed exchange rate system, of which there are many.A fixed exchange rate is typically used to stabilize the exchange rate of a currency by directly fixing its value in a predetermined ratio to a different, more stable, or more internationally prevalent currency (or currencies) to which the currency is pegged. In doing so, the exchange rate between the currency and its peg does not change based on market conditions, unlike in a floating (flexible) exchange regime. This makes trade and investments between the two currency areas easier and more predictable and is especially useful for small economies that borrow primarily in foreign currency and in which external trade forms a large part of their GDP.

Types of fixed exchange rate systems

• THE GOLD STANDARD

Under the gold standard, a country’s government declares that it will exchange its currency for a certain weight in gold. In a pure gold standard, a country’s government declares that it will freely exchange currency for actual gold at the designated exchange rate. The rules of a gold standard are quite simple. First, a country’s government declares that its issued currency (it may be coin or paper currency) will exchange for a weight in gold. Second, in a pure gold standard, a country’s government declares that it will freely exchange currency for actual gold at the designated exchange rate. This “rule of exchange” means that anyone can go to the central bank with coin or currency and walk out with pure gold. Conversely, one could also walk in with pure gold and walk out with the equivalent in coin or currency.

• PRICE SPECIE FLOW MECHANISM

The price-specie flow mechanism is a description about how adjustments to shocks or changes are handled within a pure gold standard system.

The assumptions of this mechanism are:

1. Prices are flexible

2. All transactions take place in gold

3. There is a fixed supply of gold in the world

4. Gold coins are minted at a fixed parity in each country

5. There are no banks and no capital flows

Adjustment under a gold standard involves the flow of gold between countries, resulting in equalization of prices satisfying purchasing power parity (PPP) and/or equalization of rates of return on assets satisfying interest rate parity (IRP) at the current fixed exchange rate. The only requirement for the government to maintain this type of fixed exchange rate system is to maintain the fixed price of its currency in terms of gold and to freely and readily exchange currency for gold on demand.

• RESERVE CURRENCY STANDARD

In a reserve currency system, another country’s currency takes the role that gold played in a gold standard. In other words a country fixes its own currency value to a unit of another country’s currency.A reserve currency standard is the typical method for fixing a currency today. Most countries that fix its exchange rate will fix to a currency that either is prominently used in international transactions or is the currency of a major trading partner. Thus many countries fixing their exchange rate today fix to the U.S. dollar because it is the most widely traded currency internationally.

• GOLD EXCHANGE STANDARD

A gold exchange standard is a mixed system consisting of a cross between a reserve currency standard and a gold standard.Unlike the gold standard, the central bank of the reserve country does not exchange gold for currency with the general public, only with other central banks. In general, it includes the following two rules:

• A reserve currency is chosen. All nonreserve countries agree to fix their exchange rates to the reserve at some announced rate. To maintain the fixity, these nonreserve countries will hold a stockpile of reserve currency assets.
• The reserve currency country agrees to fix its currency value to a weight in gold. Finally, the reserve country agrees to exchange gold for its own currency with other central banks within the system on demand.

There are some other fixed exchange rate variations like Basket of Currencies,Crawling peg.,Pegged within a Band, Currency Boards, Dollarization/Euroization