Question

In the past century, there have been a number of different exchange rate systems within the international monetary system, representing the range between fixed-rate and free-float. Based on the lessons learned, as evidenced in your text and class discussions, which of the 10 exchange rate arrangements defined by the International Monetary Fund (see Exhibit 2.4 in your textbook) do you believe is the most sustainable long-run exchange rate system given current global economic conditions? Defend your choice, identifying which types of nations are most likely to participate in this system.

Answer 1

INTRODUCTION

The Foreign Exchange Market is the market in which individuals,firms, and banks buy and sell foreign currencies or foreign exchange.The foreign exchange market for any currency- say, the U.S. dollar is comprised of all the locations (such as London,Paris ,Zurich,Frankfurt,Singapore,Hong Kong,Tokyo, and New York) where dollars are bought and sold for other currencies.These different monetary centers are connected electronically and are in constant contact with one another,thus forming a single international foreign exchange market.

FUNCTIONS OF THE FOREIGN EXCHANGE MARKETS

By far the principal function of foreign exchange market is the transfer of funds or purchasing power from one nation and currency to another.This is usually accomplished by an electronic transfer and increasingly through the internet.With it, a domestic bank instructs its correspondent bank in a foreign monetary center to pay a specified amount of the local currency to a person , firm or account.

The demand for foreign currencies arises when tourists visit another country and need to exchange their national currency for the currency of the country they are visiting,when a domestic firm wants to import from other nations,when an individual or firm wants to invest abroad, and so on.Conversely, a nation's supply of foreign currencies arises from foreign tourist expenditures in the nation,from export earnings,from receiving foreign investments, and so on.

A nation's commercial banks operate as clearinghouses for the foreign exchange demanded and supplied in the course of foreign transactions by the nation's residents.Four levels of transactors or participants can be identified in the foreign exchange markets.At the bottom,or at the first level, are such traditional users as tourists ,importers ,exporters,investors, and so on.These are the immediate users and suppliers of foreign currencies.At the next, or second , level are commercial banks,which act as clearing houses between users and earners of foreign exchange.At the third level are foreign exchange brokers,through whom the nation's commercial banks even out their foreign exchange inflows and outflows among themselves.Finally, at the fourth and highest level is the nation;s central bank,which acts as the seller or buyer of last resort when the nation's total foreign exchange earnings and expenditures are unequal.The central bank then either draws down its foreign exchange reserves or adds to them.

EXCHANGE RATE SYSTEMS

Exchange rate systems can be classified on the basis of the degree of government control over the determination of exchange rates.Exchange rate systems basically fall into one of the following categories ,each of which is discussed in turn:

1.FIXED

2.FREELY FLOATING

3.MANAGED FLOAT

4.PEGGED

FIXED EXCHANGE RATE SYSTEM91945-1973)

In a fixed exchange rate system ,exchange rates are not allowed to fluctuate,even if these are allowed to change,these can change only within specified narrow boundaries.A fixed exchange rate system requires much intervention of the central bank in order to maintain a currency's value within narrow boundaries.In general , the central bank has to offset any imbalance between supply and demand conditions for its currency to prohibit its value from changing.In some situations, the central bank may reset a fixed exchange rate.That is,it will devalue or reduce its currency's value against other currencies.A central bank's actions to devalue a currency in a fixed exchange rate system are termed as Devaluation,while the term Depreciation represents the decrease in a currency's value that is permitted to change in response to market conditions.

In a fixed exchange rate systems,a central bank may also revalue(increase the value of)its currency against other currencies.Revaluation refers to an upward adjustment of the exchange rate by the central bank,which the term Appreciation represents the increase in the value of a currency that is allowed to change inresponse to the market conditions.

FREELY FLOATING EXCHANGE RATE SYSTEM

In a freely floating exchange rate system,market forces determine the exchange rate without intervention by governments.Whereas a fixed exchange rate system permits no flexibility  for exchange rate movements,a freely floating exchange rate system provides for total flexibility .Under this system,whenever the demand and supply schedules for that currency change,the exchange rate gets changed accordingly.

MANAGED FLOAT EXCHANGE RATE SYSTEM

The exchange rate system prevalent today for some currencies lies somewhere between fixed and freely floating.It reflects the freely floating system in that exchange rates are permitted to change on a continuous basis and no official boundaries exist.It is similar to the fixed rate system in that governments can and sometimes do interfere to not let their currencies significantly move in a particular direction.This type of system is known as a 'managed float' or 'dirty'float.At times, the governments of various countries including Brazil,Russia,South korea and Venezuela have imposed bands around their currency to limit its degree of movement .Later , however,they removed the bands when they realized that it was difficult to maintain the currency's value within the bands.

PEGGED EXCHANGE RATE SYSTEM

Some countries use a pegged exchange rate arrangement ,under which their home currency's value is pegged to one foreign currency or to an index of currencies.Albeit the value of home currencyis fixed and constant in relation to the foreign currency to which it is pegged , it moves in line with the currency against other currencies.Some governments peg their currency's value to that of a stable currency,such as the dollar,because that forces the value of their currency to be stable .First,this forces their currency's exchange rate with the dollar to be fixed.Second,their currency will move against non-dollar currencies by the same degree as the dollar .Since the dollar is relatively more stable than most currencies,its will make their currency more stable than most currencies.

INSTRUMENTS OF FOREIGN EXCHANGE MARKET

A financial instrument is a financial medium such as bill of exchange ,bond, currency ,stock etc.which is used for the borrowing purposes.In relation to the foreign exchange market,the various financial instruments that are commonly use are as follows:

1.SPOT TRANSACTION

A spot transaction is an agreement to buy or sell a currency at the current exchange rate.To state otherwise ,it is an excahnge of one currency for another.The transaction is generally settled within two business days after