Q. Define Exchange rate systems?
Different nations have different exchange rate systems. The most significant characteristic of an exchange rate system is to what degree the country is trying to control exchange rate.
- A country can have a totally flexible exchange rate. Exchange rate is then determined solely by demand and supply in a free market without intervention of the government or central bank.
- A country may have a fully fixed exchange rate by pegging the exchange rate to another currency or to an average of several currencies. A country may, for illustration, decide that one unit of its currency would be exchanged for exactly 0.2 euro. One euro would then cost 5 of the domestic currency.
- A country can also have an exchange rate system in between these two extremes, known as a 'managed float'. In this system central bank just intervenes under special situations when it wants to influence exchange rate one way or other.
- A country can also be part of a monetary union where all countries in the union share the same currency. There is then no exchange rate between countries in the union. The union should itself select an exchange rate system regarding other currencies. The largest monetary union is the EMU, European Monetary Union with its currency the euro. Euro is flexible against other currencies (except those which are pegged to the euro).
The most common exchange rate system in western world during previous century was fixed exchange rate system. Up to 1930s, most currencies were pegged to price of gold (gold standard). After Second World War a new system was created, so-called Bretton Woods system, where every currency in the system was pegged to US dollar (USD). After the collapse of this system in 1970s, many currencies, for instance, USD, have been flexible.