Every nation has independence to choose, which exchange rate system it will follow. The choice for selecting a suitable exchange rate ranges from a flexible exchange rate or fixed exchange rate system. Under floating exchange rate system, the value of the currency is decided by market forces, while, under fixed exchange rate systems, the currency of the country is pegged against some standard of value. The choice of exchange rate is a tough task and depends significantly on the freedom of capital to flow in and out of the country. However, one negative effect of allowing the free capital flows is that it constraints a country’ choice of exchange rate system and its ability to operate an independent monetary policy
Impossible Trinity:
Thus, a country can maintain only three of three foreign exchange policies, i.e:
- Fixed Exchange Rate
- Free Capital Flows
- Independent Monetary Policy
The concept is explained using an Impossible Trinity Triangle:
Free Capital Flows
Country A Country B
Independent Monetary Policy Fixed Exchange Rate
Country C
As per this triangle, any country must choose to be on one side of the triangle, where they can adopt the policy at their own end and foregoing the policy on the opposite end. However, the decision of the nation to give up fixed exchange rate, an independent monetary policy or free capital movements, is dependant on global economic trends.
Fixed Exchange Rate System:
For Fixed Exchange rate system, most of the nations before 1970’s industrialization were following fixed exchange rate systems among national currencies, and changes in exchange rate were initiated by domestic monetary authorities only when long-term market forces warranted it. Under this system, Government assigns their currencies a par value in terms of gold or another key currency and by comparing the par value of two currencies, the official exchange rate is determined. Even today, small economies are using fixed exchange rate system where their currency is anchored to a key currency, primarily US Dollars. The main benefit offered with anchoring of a key currency is the stabilized domestic prices as prices of most of the products of the developing nations is determined in key currency market, i.e, United States. Secondly, anchoring exchange rate also ease the inflationary expectations that lead to lower interest rates, a lessening of loss of output due to disinflation and a moderation of price pressures.
Exchange Stabilization Fund:
After defining the official exchange rate of the nation’s currency, the next step is to set up an exchange stabilization fund to defend the official rate of the country. Through purchases and sales of foreign currencies, the exchange stabilization fund attempts to ensure that the market exchange rate does not move above or below the official exchange rate. Fixed Exchange Rate system may also be used by the nation’s monetary authority to pursue a balance of payments equilibrium by both, devaluing or revaluation of its currency. While the purpose of devaluation of the currency is to counteract the payments deficit by depreciating the home country’s currency, on the other hand, revaluation is to counteract the payment’s surplus by appreciating the domestic currency. Bretton Woods System is a perfect example of Fixed Exchange Rate System.
Floating Exchange Rate System:
For Floating Exchange Rate System, unlike fixed exchange rate system, the currency exchange rate is determined by the market forces through the mechanism of demand and supply. Soon after the Bretton Woods System was surrounded by a number of defaults, nations moved towards adopting Managed Floating System, which allowed the nations to alter the degree to which it intervenes in the foreign-exchange market. This system attempt to combine the market determined exchange rates with foreign exchange market intervention in order to take advantage of the best features of the floating exchange rates and flexible exchange rates.
Crawling Peg System:
Under a crawling-peg exchange-rate system, a nation makes frequent devaluations (or Revaluations) of its currency, to restore payments balance. Developing Nations suffering from high inflation rates have been major users of this mechanism. Another issue with floating exchange rate system is the Currency Crisis, which is also known as speculative attack. Currency crisis leads to excessive sales pressure on the weak currency because of inflation, weak political system and the changes in the interest rates on the world market.
Capital Controls:
Capital Controls are sometimes used by the governments in an attempt to support fixed exchange rates and prevent speculative attacks on currencies. However, Capital controls are hindered by the private sector’s finding ways to evade them and move finds into or out of the country.
Currency Board and Dollarization:
Finally, both the currency board and the process of dollarization is used to maintain the benefits of fixed exchange rate system and thus prevent any further currency crisis. While the currency board is a regulatory monetary body that takes economic actions to prevent the currency from entering into any crisis, Dollarization is the process when the residents of a country use US dollar alongside there own currency to protect the country’s growth and prosperity from the bouts of inflation, currency depreciation, and speculative attacks against the local currency.
Self Questions:
Q) Which principles relating to exchange rate are to be followed by the members of International Monetary Fund?
- Exchange rate should be not be manipulated to prevent the effective balance of payments adjustment or to gain unfair competiive advantage over other members.
- Members should act to counter short-term disorderly conditions in exchange market.
- At the time of intervention in the exchange markets, members should also take into the account, interest of other members.
Q)What is the triangle of impossible trinity?
As per the impossible trinity triangle, any nation can choose only two of the methods of the following three economic policies relating to exchange rates:
- Free Capital Flows
- Fixed Exchange Rate
- Independent Monetary Policy
And most importantly, the exchange policy so selected should be on same side of the triangle while the opposite policy should be rejected. For Instance, in the below triangle, China can only adopt, Fixed Exchange Rate and Independent Monetary Policy, while it have to forego Independent Monetary Policy. The same rule applies to other countries too.
Free Capital Flows
USA UK
Independent Monetary Policy Chinaffr3f Fixed Exchange Rate
China
Q) How Exchange Rates, Jobs and Trade Restrictions are inter-related?
Questions from Book:
Answer 1)
The decision of the country to adopt a fixed exchange rate or floating exchange rate system is based on the following economic factors:
- Size and Openness of the Economy
- Inflation Rate
- Labor-Market Flexibility
- Creditability of policymakers
- Capital Mobility
Answer 2)
Managed Floating System, which allowed the nations to alter the degree to which it intervenes in the foreign-exchange market. This system attempt to combine the market determined exchange rates with foreign exchange market intervention in order to take advantage of the best features of the floating exchange rates and flexible exchange rates.
The system was adopted because the procedural difficulties and political biases in Bretton Woods System, caused defects in the decision making process and the adjustment of par value was often delayed and discontinuous.
Answer 4)
Bretton Woods System was an international monetary system that lasted from 1946 to 1973. The main feature of this system was the adjustable peg system for commercial and financial transactions. However, when the balance of payment moved away from the long term equilibrium position, the nation could re-peg its exchange rate via devaluation or revaluation policies. This system was the combination of fixed and floating exchange rate.
Answer 5)
Under a crawling-peg exchange-rate system, a nation makes frequent devaluations (or Revaluations) of its currency to restore payments balance. Thus, this system helps in attaining the desired exchange rate levels.
Works Cited
R.J, Carbaugh. "Exchange Rate Determination." In International Economics, by Mason, 461-474. OH: South Western Cengage Learning, 2011.
