Question

State two (2) exchange rate regimes and briefly explain the advantages of adopting the stated exchange rate regimes.

Answer 1

1) Fixed exchange rate system: In a fixed exchange rate system, the exchange rate between two currencies is set by government policy. The purpose of a fixed exchange rate system is to keep a currency's value within a narrow band. It is also known as a pegged exchange rate.

Advantages:

i) Fixed rates provide greater certainty for exporters and importers.

ii) Fixed rates help the government maintain low inflation, which, in the long run, keep the interest rates down and stimulates trade and investment.

iii) Currencies with fixed exchange rates are therefore more stable and less influenced by market conditions than currencies with floating exchange rates.

iv) By controlling its domestic currency a country can keep its exchange rate low. This helps to support the competitiveness of its goods as they are sold abroad.

v) By shielding the domestic currency from volatile swings, governments can reduce the likelihood of a currency crisis.

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2) Flexible exchange rate system - The currency price of a nation is set by the forex market based on supply and demand relative to other currencies. They are not pegged nor controlled by central banks. This system became more popular after the failure of the gold standard and the Bretton Woods agreement. It can be a free-floating exchange rate system or managed-floating exchange rate system. On the one hand, pure floating regimes exist when, in a flexible exchange rate regime, there are absolutely no official purchases or sales of currency. On the other hand, managed (also called dirty) floating regimes, are those flexible exchange rate regimes where at least some official intervention happens.

Advantages:

i) Under the flexible exchange rate system, a country is free to adopt an independent policy to conduct properly domestic economic affairs.

ii) It protects the domestic economy from the shocks produced by the disturbances generated in other countries.

iii) It automatically removes the disequilibrium in the balance of payments. When there is a deficit in the balance of payments, the external value of a country’s currency falls. As a result, exports are encouraged, and imports are discouraged thereby, establishing equilibrium in the balance of payment.

iv) It does not permit exchange control and promotes free trade.

v) It eliminates the need for official foreign exchange reserves if the individual governments do not employ stabilization funds to influence the rate. Thus, the problem of international liquidity is automatically solved.