TABLE OF CONTENT

CHAPTE
R NO.
1.

CHAPTER NAME
WHAT IS EXCHANGE RATE SYSTEM &
ITS DETERMINANTS OF EXCHANGE

2.

RATE SYSTEM
OBJECTIVES & FACTORS AFFECTS

3.

EXCHANGE RATE SYSTEM

WHAT IS FLEXIBLE EXCHANGE RATE &

4.

ITS ADVENTAGES & DISADVANTAGES

ARGUMENTS IN FAVOUR AND AGAINST

5.

OF FLEXIBLE EXCHANGE RATE

MANAGED FLEXIBILITY OF EXCHANGE

6.
7.

RATE
FLEXIBLE V/S FIXED EXCHANGE RATE
CONCLUSION

Chapter-1
Exchange rate system in India

PAGE
NO.

What is an 'Exchange Rate'

The price of a nations currency in terms of another currency. An exchange rate
thus has two components, the domestic currency and a foreign currency, and can be
quoted either directly or indirectly. In a direct quotation, the price of a unit of
foreign currency is expressed in terms of the domestic currency. In an indirect
quotation, the price of a unit of domestic currency is expressed in terms of the
foreign currency. An exchange rate that does not have the domestic currency as one
of the two currency components is known as a cross currency, or cross rate.
Also known as a currency quotation , the foreign exchange rate or forex rate.
Definition of exchange rate
Price for which the currency of a country can be exchanged for
another country's currency.
The exchange rate is one of the most important determinants of a country's relative
level of economic health. Exchange rates play a vital role in a country's level of
trade, which is critical to most every free market economy in the world. For this
reason, exchange rates are among the most watched. analyzed and governmentally
manipulated economic measures. But exchange rates matter on a smaller scale as
well: they impact the real return of an investor's portfolio. Here we look at some of
the major forces behind exchange rate movements.

Overview

Before we look at these forces, we should sketch out how exchange rate
movements affect a nation's trading relationships with other nations. A higher
currency makes a country's exports more expensive and imports cheaper in foreign
markets. A lower currency makes a country's exports cheaper and its imports more
expensive in foreign markets. A higher exchange rate can be expected to lower the
country's balance of trade, while a lower exchange rate would increase it.

Determinants of Exchange Rates

Numerous factors determine exchange rates, and all are related to the trading
relationship between two countries. Remember, exchange rates are relative, and are
expressed as a comparison of the currencies of two countries. The following are
some of the principal determinants of the exchange rate between two countries.
Note that these factors are in no particular order; like many aspects of economics,
the relative importance of these factors is subject to much debate.
1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising
currency value, as its purchasing power increases relative to other currencies.
During the last half of the 20th century, the countries with low inflation included
Japan, Germany and Switzerland, while the U.S. and Canada achieved low
inflation only later. Those countries with higher inflation typically see depreciation
in their currency in relation to the currencies of their trading partners. This is also
usually accompanied by higher interest rates.

2. Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. By

manipulating interest rates, central banks exert influence over both inflation and
exchange rates, and changing interest rates impact inflation and currency values.
Higher interest rates offer lenders in an economy a higher return relative to other
countries. Therefore, higher interest rates attract foreign capital and cause the
exchange rate to rise. The impact of higher interest rates is mitigated, however, if
inflation in the country is much higher than in others, or if additional factors serve
to drive the currency down. The opposite relationship exists for decreasing interest
rates - that is, lower interest rates tend to decrease exchange rates.
3. Current-Account Deficits
The current account is the balance of trade between a country and its trading
partners, reflecting all payments between countries for goods, services, interest and
dividends. A deficit in the current account shows the country is spending more on
foreign trade than it is earning, and that it is borrowing capital from foreign sources
to make up the deficit. In other words, the country requires more foreign currency
than it receives through sales of exports, and it supplies more of its own currency
than foreigners demand for its products. The excess demand for foreign currency
lowers the country's exchange rate until domestic goods and services are cheap
enough for foreigners, and foreign assets are too expensive to generate sales for
domestic interests.
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector
projects and governmental funding. While such activity stimulates the domestic
economy, nations with large public deficits and debts are less attractive to foreign
investors. The reason? A large debt encourages inflation, and if inflation is high,
the debt will be serviced and ultimately paid off with cheaper real dollars in the
future.

In the worst case scenario, a government may print money to pay part of a large
debt, but increasing the money supply inevitably causes inflation. Moreover, if a
government is not able to service its deficit through domestic means (selling
domestic bonds, increasing the money supply), then it must increase the supply of
securities for sale to foreigners, thereby lowering their prices. Finally, a large debt
may prove worrisome to foreigners if they believe the country risks defaulting on
its obligations. Foreigners will be less willing to own securities denominated in
that currency if the risk of default is great. For this reason, the country's debt rating
(as determined by Moody's or Standard & Poor's, for example) is a crucial
determinant of its exchange rate.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to
current accounts and the balance of payments. If the price of a country's exports
rises by a greater rate than that of its imports, its terms of trade have favorably
improved. Increasing terms of trade shows greater demand for the country's
exports. This, in turn, results in rising revenues from exports, which provides
increased demand for the country's currency (and an increase in the currency's
value). If the price of exports rises by a smaller rate than that of its imports, the
currency's value will decrease in relation to its trading partners.
6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive attributes
will draw investment funds away from other countries perceived to have more
political and economic risk. Political turmoil, for example, can cause a loss of
confidence in a currency and a movement of capital to the currencies of more
stable countries.

Chapter-2
Objectives of Exchange Rate Management:

The main objectives of Indias exchange rate policy is to ensure that the economic
fundamentals are truly reflected in the external value of the rupee.
Subject to this predominant objective, the conduct of exchange policy is
guided by the following:
i. Reduce volatility in exchange rates, ensuring that the market correction of
exchange rates is effected in an orderly and calibrated manner;
ii. Help maintain an adequate level of foreign exchange reserves;
iii. Prevent the emergence of destabilisation by speculative activities; and
iv. Help eliminate market constraints so as to assist the development of a healthy
foreign exchange market.

The three main factors which affect the exchange rate are as
follows:
1. Purchasing Power Parity: The Relative Price Levels
2. Rate of Inflation and Exchange Rate
3. Interest Rates and Exchange Rate.
1. Purchasing Power Parity: The Relative Price Levels:
If there are no restrictions imposed on trade by the countries the exchange rate
between two national currencies is allowed to adjust freely and with the further
assumption that costs of transport of goods between the countries is nil, then the

exchange rate between the two currencies will reflect the differences in the price
levels in the two countries.
This is because with the above-mentioned assumptions if the price of the same
good BPL TV set is lower in Britain than in India, then it will pay traders to buy
the BPL TV sets in Britain and sell them in India. This will reduce the supply of
TV set in Britain pushing up its price there and increase the supply of TV sets in
India and thus causing a decline in its price in India.
This process would continue till the price differential of the same quality of T.V.
sets is eliminated and the same price of TV set prevails in the two countries. Thus,
if law of same price holds and each country consumes the same market basket of
goods, the exchange rate between the two currencies would be determined by the
relative price levels in the two countries.
For example, if prices in Britain and India are such that a pair of same quality of
shoes costs 5 pound in England and 350 rupees in India, then the exchange rate
between rupees and pound would be 1 pound for 70 rupees.
If the exchange rate between the two is different from this, it will be possible for
the businessmen to make profits in sending pairs of shoes from a country to the
other depending on the price levels in the two countries. We therefore conclude
that price levels of commodities in the different countries influence the exchange
rate between their currencies. It may however be noted that it is only in the long
run and with no restrictions on the trade between the two countries that relative
price level in the two countries will be reflected in the exchanges rate.

2. Rate of Inflation and Exchange Rate:

Having shown the effect of relative price levels in the countries on the exchange
rate between their currencies, we can now explain how a relatively higher rate of
inflation in a country can affect the exchange rate of its currency. Suppose in India
a relatively higher rate of inflation prevails than in the USA, how will it affect the
exchange rate between the rupee and dollar?
A relatively higher rate of inflation causing rise in prices of the goods in India as
compared to those in the USA will make US goods relatively cheaper and the
Indian goods expensive. This will serve as incentive for the Indian individuals and
firms to increase their imports of goods from USA. This will raise the demand for
US dollars shifting the demand curve for dollars in the foreign exchange market to
the right, as shown in Fig. 35.4 where the demand curve is shown to have shifted
from DD to DD under the influence of higher rate of inflation in India.

However, at the same time due to higher price

level American people will find Indian goods more expensive and as a result will
reduce their imports of Indian goods. This will cause a decline in exports of goods
from India to the USA, shifting the supply curve of dollars to the left to SS.
Both these effects of a higher price level due to higher rate of inflation in a country,
namely, rise in imports of US goods into India and the reduction in Indian exports
to the USA will cause the foreign exchange rate of dollar in terms of rupees to rise
and the price of Indian rupee in terms of dollar will fall. Thus, as a result of higher
rate of inflation in India, the US dollar will appreciate and the Indian rupee will
depreciate (See Figure 35.4).

3. Interest Rates and Exchange Rate:

Another important factor influencing the exchange rate is the interest rate in a
country relative to interest rate of other countries with which it trades its goods.
Suppose there are no restrictions imposed by the Governments on the flow of funds
between the countries.

Assume that interest on securities or bonds in USA is 5 per cent whereas it is 8 per
cent in India. Thus businessmen, firms, banks etc., with funds to invest would
obviously have incentive to buy securities and bonds of US companies. That is,
there will be flight of capital from the USA or Capital inflows into India as the
American as business corporations, firms, banks etc. will use their funds to
purchase high-yielding Indian securities.
In order to buy the Indian securities, they will have to convert dollars into rupees,
and thus increasing the demand for dollars. Consequently, the supply of dollar
curve will shift to the right. This will pull down the foreign exchange rate of dollar
in terms of rupees (Conversely, the exchange rate of rupee in terms of dollar will
appreciate). Thus, a relatively higher interest rate in India as compared to India
would lead to the depreciation of dollar and appreciation of rupee. This is what
actually happened in India in the years 2003 and 2004.

Figure 35.5 illustrates the effect of higher

interest rates in the USA on the dollar-rupee exchange rate. Initially, the demand
for and the supply of US dollar are given by the curves DD and SS respectively.
The balance between the two determines OR (or Rs. 45.50 per dollar) as the
exchange rate between the two.
With the flow of United States funds in the India to buy the Indian securities and
shares and stocks, the supply curve for dollars shifts to the right to the new position
SS (dotted) and lower the equilibrium exchange rate to OR (Rs. 44.50 per dollar)
is determined.
It may be noted that during the early eighties, the Federal Reserve Bank of USA
adopted a tight money policy to fight inflation which caused very high interest
rates in USA. These high interest rates attracted a lot of foreign capital, particularly
from Japanese firms which due to high saving rate in Japan had a large amount of
funds to make investment in American bonds. To purchase American bonds
Japanese had to convert Yens into dollars. This caused the increase in demand for
dollars and caused a sharp rise in the price of dollar. It is thus clear that like the
relative price levels, relative interest rates can also have a significant effect on the
exchange rate.

Chapter-3
What is flexible exchange rate system
Definition
An exchange rate which fluctuates depending on the supply and demand of a
currency in relation to other currencies. If there is a high demand for a particular

currency, its exchange rate relative to other currencies increases, on the other hand,
if there is less demand, its value decreases. Opposite of fixed exchange rate.

Advantage of Flexible Exchange Rates

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.
4. Solutions to Balance of Payment Problems:
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 stabilization 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 promotes 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 rates are 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.

Disadvantage of Flexible Exchange Rates

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 arc 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 largescale 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.

Chapter-4
ARGUMENTS IN FAVOUR OF FLEXIBLE EXCHANGE RATE
1.Ensures balance of payments equilibrium :
In flexible exchange rate, especially in a floating exchange exchange Rate system,
the exchange rate automatically adjust the imbalance in the balance of payment
through demand and supply forces. A deficit in the balance of payments leads to
depreciation of currency resulting in an increase in exports and decrease in
imports.
2. Monetary autonomy:
Flexible exchange rate system provides monetary autonomy to the authorities.
Each country under this system is free to follow inflationary or deflationary
policies. in other words independent monetary policy can be pursued by an
individual country rather than linking it with other countries as is the case under
fixed exchange rate.
3.Promotes economic stability:

According to Milton friedman the flexible exchange rate system is more conducive
to economic stability. It is easier to allow exchange rate to appreciate or depreciate
for external adjustment rather than initiate price changes.
4.Insulate domestic economy:
Domestic economy under the flexible exchange rate can operate independently to a
great extent. An appreciation of the domestic currency would prevent the import
of other countries inflation. Under fixed exchange rate, a country will enjoy
surplus in the balance of payments when the rest of the world has inflation but in
turn will be subjected to inflation due to increase in money supply.
5.Stabilises the private speculation:
Speculators who buy at a low price and sell at a higher value, narrow d;own the
gap between the two prices. Thus the speculative activities move the exchange
rate towards its fundamental equilibrium value.
6.Easy to determine the exchange rate:
An obvious merit of flexible exchange rate is its simplicity. Just as the price ;of a
commodity is determined by demand and supply, the rate of exchange too is
determined on the basis of demand and supply of foreign exchange.
7.Settles at natural level:
A system of flexible exchange rates enables the rates find their natural levels as
per the forces of demand and supply.
8.Smooth adjustment in balance of payment:
Flexible exchange rate bring about a smoother adjustment in the balance of
payment. As scammel says of all the variables, the exchange rate is the easiest to

alter . as soon as there is a deficit in the a balance of payment, the rate

depreciates, exports go up, imports come down and balance payments is brought
equilibrium.
9.Suitable for full employment:
Flexible rates are suitable to countries seeking to follow the policy of full
employment. Inflation and deflation inflicted upon economics under gold standard
are not necessary under flexible exchange rates. Flexible rates reflect the true cost
price structure relationship.

ARGUMENTS AGAINST FLEXIBLE EXVHANGE RATE

1.Creates uncertainty:
Frequent fluctuations in the exchange rate creates an environment of uncertainty
for exports and importers. They remain unsure about the amount required for the
payment or the one which they expect to receive.
2.Discourages investment and borrowing:
Foreign investment is discouraged due to uncertainty. So also international lending
and borrowing. Thus the flexible exchange rate, it is argued, is not conductive for
promoting economic growth.
3.Lacks stability in macroeconomic policies:
Under flexible exchange rate system internal policies undergo frequent changes in
order to prevent wild fluctuation in exchange rate. Whereas under fixed exchange
rate such frequent changes are nod needed.

4.Irrational speculation:
Under flexible exchange rate, speculation is continuous. Speculators may have a
wrong assessment of the strength and weakness of different currencies. Such
wrong judgment lead to irrational speculation and destabilization of the exchange
rate.

5.Poor international co-operation:

Flexible exchange rate does not bring in the co-operation between the countries.
Since each country allows the exchange rate to be determined in the market, it is
not binding on them to establish co-operation with other countries. Thus flexible
exchange rate may not be suitable for open economies.
6.Inflationary in nature :
Flexible exchange rate, it is agreed, has an inherent inflationary bias because
depreciation increases prices of traded goods but appreciation does not cause
parallel reduction in prices. Thus flexible exchange rate may result in frequent
increases in prices.
7.Unstable because of small trade elasticities:
A changes in exchange rate may create instability because it may increase the price
more than it decreases the quantity of imports. Depreciation also may not jincrease
exports if demand elasticity is small.
8.Causes of structural unemployment:
Under the flexible exchange rate, depreciation of currency may lead to an increase
in cost of production due to higher imports price. An increase in domestic price

subsequenlty reduces demand for exports. This may cause structural

unemployment specially in developing countries.

Chapter-5

Managed Flexibility of Exchange Rate!

Against the two extremes of rigidly fixed and freely flexible exchange rates, a
system of controlled or managed flexibility is suggested on practical considerations
into the exchange rate regime.
The focus on intermediate regime between fixed and floating exchange rate is
desirable for a prudency to eliminate the drawbacks and capture the advantages of
both extreme systems.
Under the managed or controlled flexibility of exchange rate system, the scope of
the range of flexibility around fixed par values is determined by the country as per
its economic need and the prevailing trend in the international monetary system.
Managed floating exchange rate system is essentially based on the par value
concept under the IMF guidelines.
Managing or controlling exchange rates requires the country to intervene in the
foreign exchange market time to time in view of the emerging BOP disequilibrium.

Since, the monetary authority or the central bank of the country holds large amount
of the foreign exchange it can manipulate, thus, manage/control the exchange rate
(price of the foreign currency in terms of domestic currency) through its
intervention of manipulating the demand or supply magnitude in the forex market.
For instance, when there is excess of supply of the foreign currency which in
natural course would lead to the appreciation of the external value of home
currency and this can be prevented by resorting to large- scale buying of the
foreign currency by the central bank.
The central bank intervenes the forex market to adjust a manipulated demand
corresponding to the changing supply. Similarly, where there is a situation of
high/excessive demand, the central bank may release more supply of the foreign
currency for appropriate rate adjustment. The point is illustrated in Fig. 5.

In Fig. 5 OR is the equilibrium rate of exchange, assumed to be corresponding with

par value. At the prevailing rate of exchange OR, if the demand for dollar in the
Indian foreign market exceeds the current supply (by e-x), the market tendency
will be to push up the exchange rate at OR, (since, demand curve is now implied to
be vertical at Q point, intersecting supply curve at b).

If the Reserve Bank of India seeks to maintain the exchange rate at original level, it
would intervene in the market and sell/supply an additional amount of dollars MQ
to meet the shortage (since at unintervened exchange rate OR, supply-demand gap:
ab requires MQ shortage to be covered up).
When the supply of dollar is adjusted through central bank intervention in this
manner, the external value of home currency (Rs. in our illustration) in terms of
foreign currency ($ in our illustration) is maintained at the original position (OR).
This, however, implies in reality that the rupee is overvalued in terms of dollar. The
rupee/home currency is posed as strong though actually it is weak.
Similarly, when there is excess of supply of dollar (e-x) at OR, the floating
exchange rate would be settled at a lower rate OR1. To avoid this, the central bank
may resort to buy the dollar. The additional demand to be adjusted up to MQ (since
at un intervened exchange rate OR, demand-supply gap: ab requires MQ
deficiency of demand to be filled in). In this case, the Indian Rupee is undervalued.
The Rupees is, thus, posed as weak though it is strong.
When rupee is undervalued purposely, the goal is to boost up exports and reduce
the trade deficit and correct the BOP situation.
In short, the objective of managed or controlled exchange rate is to achieve BOP
equilibrium through appropriate intervention by the monetary authority. It is also
aimed at curbing speculation in the forex market.
An alternative explanation for pegging the exchange rate under managed flexibility
system is provided in Fig. 6.

Suppose, the monetary authority wants to peg the exchange rate at OR. It has to
intervene in the forex market by using its foreign exchange reserves. Say, if
demand for dollar (foreign exchange) increases demand curve shifts from D to
D1 the exchange rate at OR can be maintained by releasing additional amount
of dollar supply into the market. This would prevent depreciation of exchange rate.
If supply of dollar rises supply curve shifts from S to S1 then the central bank
should resort to buy ab amount. In actual practice, some margin is allowed around
the peg for the exchange rate to fluctuate within a narrow limit. In Fig.6, these
margins are shown as H and L limits. In such case, when demand for forex
increases, the central bank has to sell cd amount of dollar and if supply increases, it
has to buy of amount of dollar in the course of intervention.
Under the managed exchange rate system, however a paradoxical situation may
emerge when there is persistent rise in the trade-deficit and overvalued home
currency is maintained for a long-time as happened with the U.S. dollar vs its trade
deficit during 1975- 85.
A value judgement in managed flexibility is required in choosing to maintain a
certain value for its currency through direct intervention in the foreign exchange

market. Moreover, the BOP equilibrium just cannot be achieved merely by

manipulation of exchange rates all the time.
The IMF has recognised the trend towards managed flexibility of exchange rates
and issued some guidelines and norms as code of conduct in 1974, to deal with the
following situation:
(a) Day-to-day and week-to-week fluctuations in exchange rates.
(b) Month-to-month and quarter-to-quarter fluctuations in exchange rates.
(c) Medium-term evolution of exchange rates. There is, however, no universally
agreed and easily measurable concept of an effective exchange rate which can be
used for surveillance in connection with the guidelines for floating.

Chapter-6
Flexible v/s fixed exchange rate

Major types of foreign exchange rates are as follows:

1. Fixed Exchange Rate System (or Pegged Exchange Rate System).
2. Flexible Exchange Rate System (or Floating Exchange Rate System).
3. Managed Floating Rate System.
1. Fixed Exchange Rate System:

Fixed exchange rate system refers to a system in which exchange rate for a
currency is fixed by the government.
1. The basic purpose of adopting this system is to ensure stability in foreign trade
and capital movements.
2. To achieve stability, government undertakes to buy foreign currency when the
exchange rate becomes weaker and sell foreign currency when the rate of exchange
gets stronger.
3. For this, government has to maintain large reserves of foreign currencies to
maintain the exchange rate at the level fixed by it.

4. Under this system, each country keeps value of its currency fixed in terms of
some External Standard.
5. This external standard can be gold, silver, other precious metal, another
countrys currency or even some internationally agreed unit of account.
6. When value of domestic currency is tied to the value of another currency, it is
known as Pegging.
7. When value of a currency is fixed in terms of some other currency or in terms of
gold, it is known as Parity value of currency.
For, Merits and demerits of Fixed Exchange Rate System, refer Power Booster.
Devaluation and Revaluation:
Devaluation refers to reduction in the value of domestic currency by the
government. On the other hand, Revaluation refers to increase in the value of
domestic currency by the government.
Devaluation Vs. Depreciation:

Basis

Devaluation

Depreciation

Meaning:

Devaluation refers to Depreciation

reduction in price of

refers to fall in

domestic currency in

market price

terms of all foreign

of domestic

currency in
terms of a
foreign
currency under
flexible
currencies under fixed exchange rate
exchange rate regime. regime.
It takes place
due to market
forces of
Occurrence:

It takes place due to

demand and

Government.

supply.
It takes place

It takes place under

under flexible

Exchange Ratefixed exchange rate

exchange rate

System:

system.

system.

2. Flexible Exchange Rate System:

Flexible exchange rate system refers to a system in which exchange rate is

determined by forces of demand and supply of different currencies in the foreign
exchange market.
1. The value of currency is allowed to fluctuate freely according to changes in
demand and supply of foreign exchange.

2. There is no official (Government) intervention in the foreign exchange market.

3. Flexible exchange rate is also known as Floating Exchange Rate.
4. The exchange rate is determined by the market, i.e. through interactions of
thousands of banks, firms and other institutions seeking to buy and sell currency
for purposes of making transactions in foreign exchange.

Fixed Exchange Rate System Vs Flexible Exchange Rate System:

Basis

Fixed Exchange

Flexible

Rate

Exchange Rate

It is officially

It is determined

fixed in terms of by forces of

Determination

gold or any other demand and

of Exchange

currency by

supply of foreign

Rate:

government.

exchange.
There is no

There is complete government

government

intervention and

control as only

it fluctuates

government has

freely according

Government

the power to

to market

Control:

change it.

conditions.

Stability in

The exchange rate The exchange

generally remains
stable and only a
small variation is rate keeps on
Exchange Rate: possible.

changing.

3. Managed Floating Rate System:

Traditionally, International monetary economists focused their attention on the

framework of either Fixed or a Flexible exchange rate system. With the end of
Bretton Woodss system, many countries have adopted the method of Managed
Floating Exchange Rates.
It refers to a system in which foreign exchange rate is determined by market forces
and central bank influences the exchange rate through intervention in the foreign
exchange market.
1. It is a hybrid of a fixed exchange rate and a flexible exchange rate system.
2. In this system, central bank intervenes in the foreign exchange market to restrict
the fluctuations in the exchange rate within certain limits. The aim is to keep
exchange rate close to desired target values.
3. For this, central bank maintains reserves of foreign exchange to ensure that the
exchange rate stays within the targeted value.
4. It is also known as Dirty Floating.

CONCLUSION

There is no right answer for which exchange rate is better. Advanced

and emerging economy may gain from floating rate.
Replacement of new factors new once in the era globalization,
informatization and technical progress play the leading role. In case of
poor economical policy and non-balanced government management of
the economy can reduce all the advantages of flexibility.
Liberalization of financial market exceed the risk of instability and the
future is promising greater perspectives for the countries which financial
system is based on the floating exchange rate system.
Flexible exchange rate system offers better opportunities for successful
economical development than fixed exchange rate system.