Exchange Rate Systems and The Cost and Benefit of Each Exchange Rate System for The Economy as a Whole
This article discuss briefly different Excahnge rate regimes. In addition, it discuss the cost and benefit of each system. As well, it highlights the viability of floating exchange rate system in the context of compleixity and unpredictable economic shocks and the responsiveness of price mechanism and its benefits.
Exchange Rate Systems and the cost and benefit of each Exchange Rate system for the economy as a whole
Definition of Exchange rate
If any country embarked on trade they must be able to have a system of exchanging one currency for another in order to receive and pay in one currency because one currency is not a legal tender in another.
Different Exchange rate Regimes
The exchange rate regimes can be classified to the following categories:
Floating exchange rate system
Managed or pegged exchange rate system
Semi-fixed exchange rate system
Fully Fixed exchange rate system
Monetary Union with other countries
Important characteristics of Floating exchange rate system
In a floating exchange rate system the value of a currency in relation to other currencies are determined by demand and supply of that currency. In addition, there is no target set for the currency value by central financial regulatory bodies or central banks. In a floating exchange rate system the central financial authorities need not to intervene in the currency market or exchange rate market.
The Characteristics of Managed Exchange rate systems
Like the Floating exchange rate system the managed exchange rate system also the demand and supply of a currency usually determine the value of a currency. However for domestic demand management the government intervenes in the market by affecting interest rates. However there is no intervention to affect the long-term value of the currency. However, in a managed exchange rate system there are limits to the effectiveness of intervention due to some market forces counteracting the effects of changes interest rate on the value of currency. The stronger version of managed exchange rate system is the semi-fixed exchange rate system. In this system have two bands lower and higher. The monetary policy is keep the exchange rate between these two bands. However if the monetary policy is ineffective then as a last resort it can re-evaluate the currency and set the value of the currency as in the fixed exchange rate system.
Fixed exchange rare system
In a fixed exchange rate system the currency value is pegged. That is it does not have no fluctuation from the central rate. In this system it can achieve exchange rate stability at the expense of domestic stability. However, in this system a country can gain competitiveness by reducing its costs below that of other countries because it knows that the currency is fixed. The currency boards of Argentina and China’s Fixed exchange rate system are examples of fixed exchange rate system.
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