In this article we will discuss about:- 1. Meaning of Rate of Exchange 2. Types of Exchange Rates 3. Determination 4. Equilibrium Rate 5. Factors 6. Fixed and Flexible Exchange Rates 7. Examples.
Meaning of Rate of Exchange:
The rate at which one currency is exchanged for another is called the rate of exchange. The rate of exchange is the price of one currency stated in terms of another currency. For example, if one U.S. dollar exchanges for 15 Indian rupees, then the rate of exchange is $ 1= Rs.15 or Re.1 = 1/15 = .66 dollars. It means that what $1 can purchase in America, Rs. 15 can purchase in India. In other words, the rate of exchange expresses the external purchasing power of a home currency.
According to Crowther, the rate of exchange “measures the number of units of one currency which will exchange in the foreign exchange market for another.” In the words of Anatol Murad, “The ratio at which one country’s currency can be exchanged for another is the rate of exchange between these two currencies.” According to Sayers, “the prices of currencies in terms of each other are called foreign exchange rate.”
Types of Exchange Rates:
In the foreign exchange market, at a particular time, there exists, not one unique exchange rate, but a variety of rates, depending upon the credit instruments used in the transfer function.
Major types of exchange rates are as follows:
i. Spot Rate:
Spot rate of exchange is the rate at which foreign exchange is made available on the spot. It is also known as cable rate or telegraphic transfer rate because at this rate cable or telegraphic sale and purchase of foreign exchange can be arranged immediately. Spot rate is the day-to-day rate of exchange.
The spot rate is quoted differently for buyers and sellers. For example, $ 1= Rs 15.50 for buyers and $ 1= Rs 15.30 for the seller. This difference is due to the transport charges, insurance charges, dealer’s commission, etc. These costs are to be born by the buyers.
ii. Forward Rate:
Forward rate of exchange is the rate at which the future contract for foreign currency is made. The forward exchange rate is settled now but the actual sale and purchase of foreign exchange occurs in future. The forward rate is quoted at a premium or discount over the spot rate.
iii. Long Rate:
Long rate of exchange is the rate at which a bank purchases or sells foreign currency bills which are payable at a fixed future date. The basis of the long rate of exchange is the interest on the delayed payment.
The long rate of exchange is calculated by adding premium to the spot rate of exchange in the case of credit purchase of foreign exchange and deducting premium from the spot rate in the case of credit sale. If the spot rate is £1= $ 2.80 and the rate of interest is 6%, then on 30 days bill, $ 0.014 will be added per pound in case of credit purchase and deducted in case of credit sale of dollars.
iv. Fixed Rate:
Fixed of pegged exchange fate refers to the system in which the rate of exchange of a currency is fixed or pegged in terms of gold or another currency.
v. Flexible Rate:
Flexible or floating exchange rate refers to the system in which the rate of exchange is determined by the forces of demand and supply in the foreign exchange market. It is free to fluctuate according to the changes in the demand and supply of foreign currency.
vi. Multiple Rate:
Multiple rates refer to a system in which a country adopts more than one rate of exchange for its currency. Different exchange rates are fixed for importers, exporters, and for different countries.
vii. Two-Tier Rate System:
Two-tier exchange rate system is a form of multiple exchange rate system in which a country maintains two rates, a higher rate for commercial transactions and a lower rate for capital transactions.
Determination of Exchange Rate:
Rate of exchange is the price of one currency in terms of another currency. Therefore, like other prices, the rate of exchange is also determined in accordance with the general theory of value, i.e., by the interaction of the forces of demand and supply.
In other words, the exchange rate in a free exchange market is determined at a level where demand for foreign exchange is equal to the supply of foreign exchange.
a. Supply of Foreign Exchange:
The supply of foreign exchange comes from- (a) the domestic exporters who receive payments of foreign currency; (b) the foreigners who invest and lend in the home country; (c) domestic residents who repatriate capital funds previously sent abroad; (d) the domestic residents who receive gifts from abroad.
The supply schedule for foreign exchange represents a functional relationship between different rites of exchange and the corresponding amounts of foreign exchange supplied. The supply schedule slopes upward to the right, indicating that at higher exchange rates larger amounts of foreign exchange are offered for sale. In Figure 1, S £ (= D$) is the supply scheduled for pound.
Its positive slope shows that when the exchange rate of pound in terms of dollars rises (which also means that the exchange rate of dollar in terms of pounds falls), the America exporters will increase the supply of pounds. Because sellers of pounds are buyers of dollars, the supply schedule for pounds is also the demand schedule for dollars.
b. Demand for Foreign Exchange:
Foreign exchange is demanded- (a) by the domestic residents to import goods and services from abroad; (b) by the domestic residents investing and lending abroad; (c) by the foreign residents to repatriate funds previously invested in the home country; (d) for sending gifts to foreign countries.
The demand schedule for foreign exchange shows a functional relationship between different rates of exchange and the corresponding amounts of foreign exchange demanded. The demand schedule slopes downward to the right, indicating that greater amounts of foreign currency are demanded at lower rates of exchange. In Figure 1, D £ (= S$) is the demand schedule for pound.
Its negative slope shows that when the pound is cheap in terms of dollar (which also means that dollar is dearer in terms of pound), Americans want larger amounts of pounds because they spend more on British goods. Since the buyers of pounds are the sellers of dollars, the demand schedule for pounds is also the supply schedule for dollars.
Equilibrium Rate of Exchange:
Equilibrium rate of exchange is determined at the point where demand for foreign exchange becomes equal to the supply of foreign exchange. In Figure 1, demand schedule for pounds, i.e., D £ (= S$), intersects the supply schedule for pounds, i.e., S £ (= D$), at point E. The equilibrium rate of exchange is OR and at this rate OM amounts of pounds are demanded as well as supplied. Any rate of exchange above or below OR will represent disequilibrium position and will be unstable.
For example, at OR1 rate, there exists excess supply for foreign exchange, i.e., the supply of pounds exceeds the demand for pounds (R1S1 > R1D1). This will lead to a fall in the pound rate of exchange and bring it down to the equilibrium level OR. Similarly, OR2 rate represents a situation of excess demand, i.e., the demand for pounds exceeds the supply of pounds (R2D2 > R2S2). This will push up the pound exchange rate to the equilibrium level OR.
Different theories of exchange rate determination attempt to explain only the equilibrium or normal or long period rates of exchange. The market or the day-to-day rates of exchange, however, are subject to fluctuations in response to the changes to the supply and demand for international money transfers.
There are a host of factors which influence the supply of and demand for foreign exchange and thus are responsible for the fluctuations in the rate of exchange.
Important among them are given below:
1. Trade Movements:
Changes in the imports and exports cause changes in the demand for and supply of foreign exchange which in turn, lead to fluctuations in the rate of exchange. If the imports exceed exports, the demand for foreign exchange increases and, as a result, the rate of exchange of native currency will fall and move against the native country.
On the other hand, if exports exceed imports, the demand for foreign exchange decreases and the rate of exchange rises and moves in favour of the native country.
2. Capital Flow:
Capital flow from one country to another brings changes in the rate of exchange. If, for example, capital is exported from America for investment in India, the demand for India rupee will increase in the foreign exchange market. As a consequence, the rate of exchange of Indian rupee in terms of American dollar will rise.
3. Granting of Loans:
If a country gets loans from some foreign country, the supply of the foreign currency will increase. As a result, the rate of exchange will move in favour of the home currency and against the foreign currency.
But, at the time of repayment of loan or granting loan to the foreign country, the supply of foreign currency will fall and the rate of exchange will move against the home currency and in favour of the foreign currency.
4. Sale and Purchase of Securities:
Sale and purchase of foreign securities influence the demand for foreign exchange, and, thereby, the exchange rate. When the residents of a country purchase foreign securities, the demand for foreign currency Increases. As a result, the value of home currency falls, i.e., the rate of exchange moves against the home currency and in favour of foreign currency.
5. Banking Operations:
Banks are the dealers in foreign exchange. They sell drafts, transfer funds, issue letters of credit, and accept foreign bills of exchange. When a bank issues drafts or other credit instruments on its foreign branches, it increases the supply of home currency in the foreign exchange market. As a result, the rate of exchange moves in favour of the home currency and against the foreign currency.
Speculation (or anticipation about the future changes) in the foreign exchange market also causes variations in the rate of exchange. If the speculators expect the value of foreign currency to rise, they begin to buy foreign currency in order to sell it in future to earn profit. By doing so, they tend to increase the demand for foreign currency and raise its value.
On the other hand, if the speculators anticipate a fall in the future value of foreign currency, they will sell their foreign exchange holdings. As a result of this increase in the supply of foreign exchange, the rate of exchange will move against foreign currency and in favour of home currency.
When the government of a country gives protection to the domestic industries, it tends to discourage imports from other countries. As a consequence, the demand for foreign currency will decrease and the rate of exchange will move in favour of the home currency and against the foreign currency.
8. Exchange Control:
The policy of exchange control also brings about changes in the rate of exchange. Generally, various measures of exchange control involve restrictions on imports which leads to a fall in the demand for foreign currency. As a result, the rate of exchange moves in favour of the home currency and against the foreign currency.
9. Inflation and Deflation:
Changes in the internal value of money also reflect themselves in the similar changes in the external values. During inflation, the internal value (or the purchasing power) of home currency falls and there will be outflow of foreign capital from the country to avoid financial losses. As a result, the demand for foreign currency will increase and the external value of home currency will fall.
On the contrary, during deflation, the internal value (or the purchasing power) of the home currency rises and there will be inflow of foreign capital to realise financial gains from the relative appreciation of the value of foreign currency and a change in the exchange rate in favour of home currency and against foreign currency.
10. Financial Policy:
Policy of deficit financing leads to inflationary conditions in the country. As a result, the foreign capital will start leaving the country, the supply of foreign exchange will fall and the rate of exchange will turn in favour of foreign currency and against home currency.
11. Bank Rate:
Changes in the bank rate cause fluctuations in the exchange rate. When the central bank of a country raises the bank rate, there will be inflow of foreign capital with a view to earn higher interest income. As a result, the supply of foreign currency increases and the rate of exchange moves against the foreign currency and in favour of home currency.
On the other hand, when the bank rate is reduced, there will be an outflow of foreign capital. This reduces the supply of foreign currency and the exchange rate moves in favour of the foreign currency and against the home currency.
12. Monetary Standard:
If the country is on the gold standard, then the exchange rate will move within the limits set by upper and lower gold points. On the contrary, in a country with inconvertible paper money system, there is no limit to the fluctuations in the rate exchange.
13. Peace and Security:
The condition of peace and security in the country attracts foreign capital. This increases the supply of foreign currencies in the country and the rate of exchange moves against the foreign currencies and in favour of the home currency.
14. Political Conditions:
Political stability also encourages inflow of foreign capital in the country. As a result, the supply of foreign currencies increase and their value in terms of home currency falls.
All these factors cause fluctuations in the exchange rate only in the system of flexible exchange rates. However, if the country adopts the policy of complete exchange control, and the exchange rate is pegged at a certain level, there will be no variations in the rate of exchange.
Broadly speaking, there can be two types of exchange rate systems:
1. Fixed exchange rate system and
2. Flexible exchange rate system.
1. Fixed Exchange Rate System:
Fixed exchange rate system is a system where the rate of exchange between two or more countries does not vary or varies only within narrow limits. Under the fixed or stable exchange rate system, the government of a country adjusts its economic policies in such a manner that a stable exchange rate is maintained; it is a system of changing lock to the key.
In the strict sense, fixed exchange rate system refers to the international gold standard (as existed before 1914) under which the countries define their currencies in gold at a ratio assumed to be fixed indefinitely.
But, in modern times, the fixed exchange rate system is identified with adjustable peg system of the International Monetary Fund (IMF) under which the exchange rate is determined by the government and enforced through pegging operations or through some exchange controls.
2. Flexible Exchange Rate System:
Flexible or free exchange rate system, on the other hand, is a system where the value of one currency in terms of another is free to fluctuate and establish its equilibrium level in the exchange market through the forces of demand and supply. Under the flexible exchange rate system, the rate of exchange is allowed to vary to suit the economic policies of the government; it is a system of changing key to the lock.
The flexible exchange rates are determined by the forces of demand and supply in the exchange market. There are no restrictions on the buying and selling of the foreign currencies by the monetary authority and the exchange rates are free to change according to the changes in the demand and supply of foreign exchange.
The main arguments advanced in favour of the system of fixed or stable exchange rates are as follows:
a. Promotes International Trade:
Fixed or stable exchange rates ensure certainty about the foreign payments and inspire confidence among the importers and exporters. This helps to promote international trade.
b. Necessary for Small Nations:
Fixed exchange rates are all the more essential for the smaller nations like the U.K., Denmark, Belgium, in whose economies foreign trade plays a dominant role. Fluctuating exchange rates will seriously affect the process of economic growth in these economies.
c. Promotes International Investment:
Fixed exchange rates promote international investments. If the exchange rates are fluctuating, the lenders and investors will not be prepared to lend for long-term investments.
d. Removes Speculation:
Fixed exchange rates eliminate, the speculative activities in the international transactions. There is no possibility of panic flight of capital form one country to another in the system of fixed exchange rates.
e. Necessary for Small Nations:
Fixed exchange rates are all the more essential for the smaller nations like the U.K., Denmark, Belgium, in whose economies foreign trade plays a dominant role. Fluctuating exchange rates will seriously disturb the process of economic growth of these economies.
f. Necessary for Developing Countries:
Fixed exchanges rates are necessary and desirable for the developing countries for carrying out planned development efforts. Fluctuating rates disturb the smooth process of economic development and restrict the inflow of foreign capital.
g. Suitable for Currency Area:
A fixed or stable exchange rate system is most suitable to a world of currency areas, such as the sterling area. If the exchange rates of the countries in the common currency area are flexible, the fluctuations in the leading country, like England (whose currency dominates), will also disturb the exchange rates of the whole area.
h. Economic Stabilisation:
Fixed foreign exchange rate ensures internal economic stabilisation and checks unwarranted changes in the prices within the economy. In a system of flexible exchange rates, the liquidity preference is high because the businessmen will like to enjoy wind fall gains from the fluctuating exchange rates. This tends to Increase price and hoarding activities in country.
i. Net Permanently Fixed:
Under the fixed exchange rate system, the exchange rate does not remain fixed or is permanently frozen. Rather the rate is changed at the appropriate time to correct the fundamental disequilibrium in the balance of payments.
j. Other Arguments:
Besides, the fixed exchange rate system is also beneficial on account of the following reasons:
(i) It ensures orderly growth of world’s money and capital markets and regularises the international capital movements.
(ii) It ensures smooth functioning of the international monetary system. That is why; IMF has adopted pegged or fixed exchange rate system.
(iii) It encourages multilateral trade through regional cooperation of different countries.
(iv) In modern times when economic transactions and relations among nations have become too vast and complex, it is more useful to follow a fixed exchange rate system.
The system of fixed exchange rates has been criticised on the following grounds:
a. Outmoded System:
Fixed exchange rate system worked successfully under the favourable conditions of gold standard during 19th century when- (a) the countries permitted the balance of payments to influence the domestic economic policy; (b) there was coordination of monetary policies of the trading countries; (c) the central banks primarily aimed at maintaining the external value of the currency in their respective countries; and (d) the prices were more flexible. Since all these conditions are absent today, the smooth functioning of the fixed exchange rate system is not possible.
b. Discourage Foreign Investment:
Fixed exchange rates are not permanently fixed or rigid. Therefore, such a system discourages long-term foreign investment which is considered available under the really fixed exchange rate system.
c. Monetary Dependence:
Under the fixed exchange rate system, a country is deprived of its monetary independence. It requires a country to pursue a policy of monetary expansion or contraction in order to maintain stability in its rate of exchange.
d. Cost-Price Relationship not Reflected:
The fixed exchange rate system does not reflect the true cost-price relationship between the currencies of the countries. No two countries follow the same economic policies. Therefore the cost-price relationship between them goes on changing. If the exchange rate is to reflect the changing cost-price relationship between the countries, it must be flexible.
e. Not a Genuinely Fixed System:
The system of fixed exchange rates provides neither the expectation of permanently stable rates as found in the gold standard system, nor the continuous and sensitive adjustment of a freely fluctuating exchange rate.
f. Difficulties of IMF System:
The system of fixed or pegged exchange rates, as followed by the International Monetary Fund (IMF), is in reality a system of managed flexibility. It involves certain difficulties, such as deciding as to- (a) when to change the external value of the currency; (b) what should be acceptable criteria for devaluation; and (c) how much devaluation is needed to reestablish equilibrium in the balance of payments of the devaluing country.
Flexible exchange rate system is claimed to have the following advantages:
1. Independent Monetary Policy:
Under flexible exchange rate system, a country is free to adopt an independent policy to conduct properly the domestic economic affairs. The monetary policy of a country is not limited or affected by the economic conditions of other countries.
2. Shock Absorber:
A fluctuating exchange rate system protects the domestic economy from the shocks produced by the disturbances generated in other countries. Thus, it acts as a shock absorber and saves the internal economy from the disturbing effects from abroad.
3. Promotes Economic Development:
The flexible exchange rate system promotes economic development and helps to achieve full employment in the country. The exchange rates can be changed in accordance with the requirements of the monetary policy of the country to achieve the planned national objectives.
The system of flexible exchange rates automatically removes the disequilibrium in the balance of payments. When, there is deficit in the balance of payments, the external value of a country’s currency falls. As a result, exports are encouraged, and imports are discouraged thereby, establishing equilibrium in the balance of payment.
5. Promotes International Trade:
The system of flexible exchange rates does not permit exchange control and promotes free trade. Restrictions on international trade are removed and there is free movement of capital and money between countries.
6. Increase in International Liquidity:
The system of flexible exchange rates eliminates the need for official foreign exchange reserves, if the individual governments do not employ stabilisation funds to influence the rate. Thus, the problem of international liquidity is automatically solved. In fact the present shortage of international liquidity is due to pegging the exchange rates and the intervention of the IMF authorities to prevent fluctuations in the rates beyond a narrow limit.
7. Market Forces at Work:
Under the flexible exchange rate system, the foreign exchange rates are determined by the market forces of demand and supply. Market is cleared off automatically through changes in exchange rates and the possibility of scarcity or surplus of any currency does not exist.
8. International Trade not Promoted by Fixed Rates:
The argument that fixed exchange rates promote international trade is not supported by historical facts of inter-war or post-war period. On the other hand under the flexible exchange rate system, the trend of the rate of exchange is generally assessed through the forward market, and the traders are protected from financial losses arising from fluctuating exchange rates. This helps in promoting international trade.
9. International Investment not Promoted by Fixed Rates:
The argument that long-term international investments are encouraged under fixed exchange rate system is not valid. Both the lenders and borrowers cannot expect the exchange rate to remain stable over a very long-period.
10. Fixed Rates not Necessary for Currency Area:
This stable exchange rate is not necessary for any system of currency areas. The sterling block functioned smoothly during the thirties in spite of the fluctuating rates of the member countries.
11. Speculation not Prevented by Fixed Rates:
The main weakness of the stable exchange rate system is that in spite of the strict exchange control, currency speculation is encouraged. This destroys the stability in the exchange value of the home currency and makes devaluation of the currency inevitable. For instance, the pound had to be devalued in 1949 mainly because of such speculation.
The following are the main drawbacks of the system of flexible exchange rates:
1. Low Elasticities:
The elasticities in the international markets are too low for exchange rate variations to operate successfully in bringing about automatic equilibrating adjustments. When import and export elasticities are very low the exchange market becomes unstable. Hence, the depreciation of the weak currency would simply tend to worsen the balance of payments deficit further.
2. Unstable Conditions:
Flexible exchange rates create conditions of instability and uncertainty which, in turn, tend to reduce the volume of international trade and foreign investment. Long-term foreign investments are greatly reduced because of higher risks involved.
3. Adverse Effect on Economic Structure:
The system of flexible exchange rates has serious repercussion on the economic structure of the economy. Fluctuating exchange rates cause changes in the price of imported and exported goods which, in turn, destabilise the economy of the country.
4. Unnecessary Capital Movements:
The system of fluctuating exchange rates leads to unnecessary international capital movements. By encouraging speculative activities, such a system causes large-scale capital outflows and inflows, thus, seriously disturbing the economy of the country.
5. Depression Effects of Capital Movements:
Speculative capital movements caused by fluctuating exchange rates may lead to the problem of extremely high liquidity preference. In a situation of high liquidity preference, people tend to hoard currency, interest rates rise, investment falls and there is large-scale unemployment in the economy.
6. Inflationary Effect:
Flexible exchange rate system involves greater possibility of inflationary effect of exchange depreciation on domestic price level of a country. Inflationary rise in prices leads to further depreciation of the external value of the currency.
7. Factor Immobility:
The immobility of various factors of production deprives the flexible exchange rate system of its advantages arising from the adoption of monetary and other policies for maintaining internal stability. Such policies produce desirable effects on production and employment only when supply of factors of production is elastic.
8. Failure of Flexible Rate System:
Experience of the flexible exchange rate system adopted between the two world wars has shown that it was a flop.
It is a debatable question whether a country should adopt a fixed or flexible exchange rate system. Both the types of exchange rate system have their relative merits and demerits.
Actual experience however, indicates that the success or appropriateness of an exchange rate system depends upon the macro-economic conditions of the country and the external shocks- (a) if the world economy itself is stable and there are no fluctuations in the trend rate of exchange, the fixed exchange rate system is likely to be quite successful. (b) If the world conditions are chaotic and the internal economy of the country relatively stable, the flexible exchange rate system will work smoothly and have little disturbing effects, (c) If, on the other hand the economy is relatively unstable and is more open to external fluctuations due to greater dependence on foreign trade, flexible exchange rate system will have destabilising effects.
Though the debate still continues over the relative merits of- (a) fixed or stable exchange rates, (b) flexible or floating exchange rates, and (c) a compromise between the two systems, it is not completely unresolved. Both theory and experience, however, have combined to resolve partly some of the key issues in the debate.
These key issues are:
(b) The risk argument; and
(a) Argument of Price Discipline:
One major argument advanced in favour of fixed rates and against flexible exchange rates is that the flexible exchange rates weaken internal price discipline and allow more inflation. The argument runs as follows- The fixed exchange rate system puts more pressure on the deficit countries to deflate more than on the surplus countries to inflate.
Thus, allowing the governments to switch over to flexible exchange rates system will on the average release more inflationary policies. This argument is correct and is supported by the fact that world inflation increased after the generalised float of August 1971.
But, whether one considers this argument for fixed or flexible exchange rates involve value judgment. It depends upon one’s view of unemployment-inflation dilemma. Those who care much about full employment and are not much bothered about price inflation might prefer flexible rates because the flexible rates enhance the ability of deficit countries to create jobs through expansionary policies. On the contrary, those who fear inflation above all are more likely to favour fixed exchange rates.
(b) Risk Argument:
The argument that flexible exchange rates expose traders and investors to greater risks is questionable. ‘The arguments needed to defend fixed exchange rates against the shocks that are experienced in any other system of exchange rates are likely to be less costly.
Under the flexible exchange rate system, one can easily insure against exchange rate risk through hedging in the forward market. On the other hand, it is much harder to insure against a sudden loss of job or sudden inflation resulting from the attempts to defend fixed exchange rate system.
(c) Argument of Destabilising Speculation:
The argument that flexible exchange rates breed; destabilising speculation is not fully supported by theory or by experience. Speculation under flexible exchange rates may be stabilising or destabilising.
If the speculators expect a fall in the price of foreign exchange (e.g., fall in dollar per pound) when it is above the trend level, and expect a rise in the price of foreign exchange when it is below the trend level, they tend to sell the foreign currency (pound) when its price is above the trend and buy it when its price is below trend.
This is called stabilising speculation. On the other hand, if the speculators expect a further rise in the price Of foreign currency (e.g., pound) when it is above the trend level and expect a further fall in the price of foreign currency (pound) when it is below the trend level, they tend to buy the foreign currency (pound) when its price is above trend and sell it when its price is below trend. This is a case of destabilising speculation.
According to Friedman, the destabilising speculation is self-eliminating because destabilising speculators will be losing money by buying high and selling low over each cycle of exchange rate movement and will go bankrupt if they continue behaving in this manner.
But, the question, whether, under a flexible exchange rate system, speculation will in reality be stabilising, or destabilising is not merely a theoretical question, but also an empirical question, and has to be answered by the study of actual facts. Such a study will bring to light many cases in which the destabilising speculators did not bother about losing money and actually lost money, but produced destabilising effects.
Historically, the success or failure of different exchange rate systems has depended upon the severity of shocks with which these systems had to deal.
1. Gold Standard Era (1870-1914):
The fixed exchange rate system under gold standard operated successfully before 1914 because the world economy itself was more stable. During this stable pre-war period, even fluctuating exchange rate regimes showed stability.
2. Inter-War Period of Instability:
In the inter-war period, the economic conditions throughout the whole world were chaotic. Fixed rates broke down and the governments were forced to shift to fluctuating exchange rate system.
Empirical studies have shown that, in the inter-war period, the flexible rate system showed signs of stabilising speculation in the countries with conditions of relative macroeconomic stability and of destabilising speculation in the countries with relatively disturbed conditions.
3. Adjustable Peg System (1944-1971):
In the more stable and faster growing post-war world economy, international monetary institutions proved more successful. The international financial order, called the Bretton Woods system, provided a modified gold exchange standard.
Under this system, the countries maintained adjustable pegs vis-a-vis the U.S. dollar. The U.S. took the responsibility of exchanging gold for dollars with foreign central banks at a fixed price.
A new institution, i.e., International Monetary Fund (IMF), was founded as a part of the Bretton Wood system. The adjustable peg system provided compromise between fixed and flexible exchange rate systems and was aimed at achieving the twin objectives- (a) to establish international harmony and stable exchange rates associated with the gold standard; and (b) to allow individual countries the freedom to pursue their own macroeconomic policies.
4. Collapse of Adjustable Peg System:
The post-war experience with adjustable pegged exchange showed that there were rare changes in exchange rates among major currencies. But, the system ceased to be feasible due to the basic flaws inherent in the system itself. It carried within itself the seeds of its own destruction.
The contradictory features of the adjustable peg system were- (a) stable exchange rates; (b) autonomous national macroeconomic policies; and (c) extensive international capital movements as a result of steady growth of international trade and liberalisation of international transactions.
The nations were unwilling to dispense with the second feature and did not like to impose controls necessary to nullify the effects of the third feature. Thus, the first feature must go. Ultimately, the adjustable peg system collapsed in 1971 and was replaced by the system of managed floating rates.
5. Managed Floating Rates (After 1971):
Since 1971, the system of managed floating rates has been adopted by most of the countries of the world. Under this system, the currency of a country is allowed to float on foreign exchange market and determine its exchange rate according to market forces.
Floating rate does not imply complete absence of official intervention. The monetary authorities may intervene to restrict the fluctuations in the exchange rate within certain limits.
6. Rules for Managed Floating:
In order to avoid disorderly fluctuations in the exchange rates and allow the national intervention in accordance with some international guidelines, various formal rules have been suggested. The IMF, on two occasions, has made general statements on the subject.
The Fund issued in 1974 the Guidelines for the Management of floating Exchange Rates, and in 1977 the Text of Executive Directors Discussions of Exchange Rate Policy Surveillance. But the debate regarding the formal rules continues.
At present, the discussion centres round four types of norms for behaviour:
(i) Leaning against the Wind:
The basic idea here is that the central banks should intervene to resist but not neutralise market forces. In other words, short-term exchange rate fluctuations should be reduced, but long-term trends should be dictated by the market.
Target values should be set for various exchange rates and the authorities should then intervene so as to move exchange rates towards these targets.
(iii) Objective Indicators:
Objective indicators should be used and the countries should alter their intervention policies when these indicators signal the existence of substantial disequilibrium.
(iv) Reference Rates:
Reference rates should be set and revised periodically at levels consistent with the international economic policies of the countries involved. The aim is not to directly reduce exchange rate fluctuations but to help prevent aggressively nationalistic intervention policies.
7. Present Position:
The present position regarding the existing exchange rate system in the world economy is that the IMF articles have been so amended as to allow the countries wide discretion in exchange practices.
The major industrial countries have managed floats relative to each other, except for the adjustable pegs of the European Monetary System. Majority of the less developed countries, on the other hand, peg to a currency or to a basket of currencies.
Thus, the current controversy does not centre over whether a general system of adjustable pegs should be reintroduced, or over the merits of fixed versus floating rates. On the other hand, the controversy is regarding whether and how intervention ought to be internationally regulated under the managed floating exchange rate system.