The exchange system in any country widely focuses on the exchange of one currency for another as well as the conversion of one currency into another currency. Moreover, the exchange system can also refer to the global market where currencies are traded virtually around the clock.
Question 1
Fixed exchange rate system
Often in the fixed exchange rate system, the government through the central bank has the power and the mandate to control the official exchange rate to another country’s currency. As a result, all other banks and agencies conducting the foreign exchange should follow the rules and regulations laid down by the central bank. The main purpose of this exchange rate system is to assist the country in maintaining the value of their currency.
Floating exchange rate system
Floating exchange rate system is a system where the value of a country’s currency value is determined by the forces of demand and supply in the market. As a result, the government has no power or ability to control the value of the currency of a country. An increase in demand and a fall in supply leads to an increase in the prices while falling in demand and an increase in supply can lead to fall in prices (Cavoli, 2014).
Pegged exchange rate system
In a pegged exchange rate system, the government stabilizes its currency by fixing the value of its currency to another separate country’s currency. As a result, investors buy underlying securities in bulk close to the expiration date of the derivative held by said, investor.
Question 2
Advantages of fixed exchange rates
- It helps to promote international trade as it ensures certainty about the foreign payment and inspires confidence among the importers and exporters.
- Helps in promoting international investment as lenders do not prepare to long for long-term investment if the cases of fluctuating exchange rates.
- Helps in stabilizing the economy of a country considering that the liquidity preferences are high since investors like to enjoy windfall gains from the fluctuating exchange rate
Disadvantages of fixed exchange rates
- Under this system, a country is usually deprived of its monetary independence
- Discourages foreign investment since they are not permanently fixed or rigid
- This system does not provide the expectations of permanently stable rates as well as continuous sensitive adjustment of a free exchange rate.
Advantages of Floating exchange rate system
- Floating exchange rate systems do not require an international manager to look over current account imbalances.
- There is no need for frequent central bank intervention in this system to protect the gold parity since there is no parity to uphold(Frenkel, 2013).
Disadvantages of Floating exchange rate system
- This system is highly volatile, and as a result, macroeconomic fundamentals cannot explain especially the short-term volatility.
- This system is also famous for its tendency to worsen existing problems such as higher inflation or unemployment.
Advantages of Pegged exchange rate system
- Pegged exchange rate system helps to keep a country’s exchange rate low by controlling its domestic currency.
- It helps to bridge the gap and improve trade relations between countries with low costs of production and those with stronger comparative currencies.
Disadvantages of Pegged exchange rate system
- It causes importing inflation considering that the country will have huge deposits which create unwanted side effects.
References
Cavoli, T. &. (2014). Intervention and Exchange Rate Regime Choice in Asia: Does the US Dollar Still Matter? (Doctoral dissertation, World Scientific Publishing).
Frenkel, J. A. (2013). The Economics of Exchange Rates (Collected Works of Harry Johnson): Selected Studies (Vol. 8). Routledge.
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