BY : DHULAR

EXCHANGE RATE SYSTEMS

AND ARRANGEMENTS IN
PRACTICE
CONTEMPORARY EXCHANGE
RATE SYSTEMS
The classification of current exchange rate
systems is based on a taxonomy developed by
IMF since 1971, which was revised in 1998
and again in 2009.
The basic purpose of revision was to allow
greater consistency and objectivity of
classifications across countries, expedite the
classification process, conserve recourses and
improve transparency, with benefits for the
IMFs bilateral and multilateral surveillance.


Key changes to the classification system include:
Replacing the current distinction between
managed and independent floating with two new
categories: floating and free floating, with clear
definitions;
Drawing a distinction between formal fixed and
crawling pegs, and arrangements that are merely
peg-like or crawl-like;
Increasing the transparency of the system by
basing it on rules that can be implemented using
specified information, with a more clearly stated
role for judgement.

Fixed Rate System
Governments (through their central bank) buy or
sell their currencies in the foreign exchange
market whenever exchange rates deviate from
their stated par values.
In present-day context a purely fixed rate system
is employed by only a few centrally planned
economies such as Cuba and North Korea.
In these economies, it is mandatory that a local
firms foreign exchange earnings be surrendered
to the central bank, which in turn pays the firm a
corresponding amount in state-owned users on
the basis of governmental priorities.
Independent Float System
The floating exchange rate regime was
formalized in January 1976 following the
collapse of the fixed exchange rate system.
Approximately 55 countries currently allow full
flexibility through an independent float, also
known as clean float.

Under the floating exchange rate system, an exchange rate is
allowed to adjust freely to supply and demand of this
currency for another.
Consequently there is usually no need for an economy to
undergo the painful adjustment process set in motion by a
decrease or increase in the money supply. This category
contains currencies of both developed countries and
developing countries.
Central bank of these countries allow exchange rates to be
determined by market forces alone.
Although some centrals may intervene in the market from
time to time, such intervention usually attempts to reduce
speculative pressures on their currency. Further, central
banks intervene only as one of many anonymous participants
in the free market in an occasional, non-continuous manner.
ARGUMENTS FOR THE
FIXED EXCHANGE RATE
SYSTEM
Types of arguments..
Monetary discipline

Volatility of exchange rates

Trade balance adjustments
Monetary discipline
A certain amount of monetary discipline are
there due to the impact of expansionary
monetary policy on inflation.
Governments and political pressures may lead
to expand money supply, leading to inflation.

Volatility of exchange rates
Freely floating rates may cause uncertainty
due to speculation in the foreign exchange
markets.
Under the floating system, international
speculators can cause wide swings in the
values of different currencies.
This swings are the result of the movement of
investment flows in search of better returns
and the enormous speed of capital flows
whose scale dwarfs that of trade flows.
Trade balance adjustments
Arguments in favour of floating rates explain
that they help in a less painful trade balance
adjustment.
Critics explain the existence of a trade deficit
through a saving investment relationship
rather than through the external value of its
currency.
Depreciation of currency leads to inflation,
because, the resulting increase in import
prices wipe out any apparent gains in cost
competitiveness.
Exchange rate Arrangements in
practice:
Classification given by the IFM in 1998-2009:

1. Exchange Arrangements with No Separate Legal
Tender
2. Currency Board Arrangements
3. Other Conventional Fixed Peg Arrangements
4. Pegged Exchange Rates within Horizontal Bands
5. Crawling Pegs
6. Exchange Rates within Crawling Bands
7. Managed Floating with No Predetermined Path for
the
Exchange Rate
8. Independently Floating
Hard Pegs
This means fixing the exchange rate between
two currencies.

A hard peg means that the country tries to
keep it's currency at the exact same exchange
rate as another currency (usually it is a country
trying to keep its currency pegged to the
USD).

Hard pegs follow the anchor currency more
strictly.
Currency Board Arrangements
Based on an explicit legislative commitment to exchange
domestic currency for a specified foreign currency at a fixed
exchange rate, combined with restrictions on the issuing
authority to ensure the fulfillment of its legal obligation.

Domestic currency will be issued only against foreign
exchange and that it remains fully backed by foreign assets,
eliminating traditional central bank functions, such as
monetary control and lender-of-last-resort, and leaving
little scope for discretionary monetary policy.

Some flexibility may still be afforded, depending on how
strict the banking rules of the currency board arrangement.

Exchange Arrangements with No
Separate Legal Tender
The currency of another country circulates as the
sole legal tender (formal dollarization)

the member belongs to a monetary or currency
union in which the same legal tender is shared by
the members of the union.

It implies the complete surrender of the monetary
authorities' independent control over domestic
monetary policy.

Other Conventional Fixed Peg
Arrangements
The country (formally or de facto) pegs its currency at a fixed rate to another currency or a
basket of currencies, where the basket is formed from the currencies of major trading or
financial partners and weights reflect the geographical distribution of trade, services, or
capital flows.

The currency composites can also be standardized, as in the case of the SDR. There is no
commitment to keep the parity irrevocably. The exchange rate may fluctuate within narrow
margins of less than 1 percent around a central rate-or the maximum and minimum value of
the exchange rate may remain within a narrow margin of 2 percent-for at least three months.

The monetary authority stands ready to maintain the fixed parity through direct intervention
(i.e., via sale/purchase of foreign exchange in the market) or indirect intervention (e.g., via
aggressive use of interest rate policy, imposition of foreign exchange regulations, exercise of
moral suasion that constrains foreign exchange activity, or through intervention by other
public institutions).

Flexibility of monetary policy, though limited, is greater than in the case of exchange
arrangements with no separate legal tender and currency boards because traditional central
banking functions are still possible, and the monetary authority can adjust the level of the
exchange rate, although relatively infrequently.

Soft Pegs
A soft peg is a term used for countries with a
fixed exchange rate regime.
Soft pegs generally let their exchange rate
fluctuate through a desired bracket.
A soft peg means the country tries to keep the
currency exchange rate basically about the
same, but allows it to fluctuate up and down a
little.

Pegged Exchange Rates within
Horizontal Bands
The value of the currency is maintained within certain
margins of fluctuation of at least 1 percent around a
fixed central rate or the margin between the maximum
and minimum value of the exchange rate exceeds 2
percent.

It also includes arrangements of countries in the
exchange rate mechanism (ERM) of the European
Monetary System (EMS) that was replaced with the ERM
II on January 1, 1999.

There is a limited degree of monetary policy discretion,
depending on the band width.

Crawling Pegs
The currency is adjusted periodically in small amounts at a
fixed rate or in response to changes in selective quantitative
indicators, such as past inflation differentials vis--vis major
trading partners, differentials between the inflation target
and expected inflation in major trading partners, and so
forth.

The rate of crawl can be set to generate inflation-adjusted
changes in the exchange rate (backward looking), or set at a
preannounced fixed rate and/or below the projected
inflation differentials (forward looking).

Maintaining a crawling peg imposes constraints on
monetary policy in a manner similar to a fixed peg system.

Exchange Rates within Crawling
Bands
The currency is maintained within certain fluctuation margins of at
least 1 percent around a central rate-or the margin between the
maximum and minimum value of the exchange rate exceeds 2
percent-and the central rate or margins are adjusted periodically at
a fixed rate or in response to changes in selective quantitative
indicators.
The degree of exchange rate flexibility is a function of the band
width. Bands are either symmetric around a crawling central parity
or widen gradually with an asymmetric choice of the crawl of upper
and lower bands (in the latter case, there may be no preannounced
central rate).
The commitment to maintain the exchange rate within the band
imposes constraints on monetary policy, with the degree of policy
independence being a function of the band width.

Managed Floating with No
Predetermined Path for the Exchange Rate
The monetary authority attempts to influence the
exchange rate without having a specific exchange
rate path or target.

Indicators for managing the rate are broadly
judgmental (e.g., balance of payments position,
international reserves, parallel market
developments), and adjustments may not be
automatic. Intervention may be direct or indirect.

Independently Floating
The exchange rate is market-determined, with any
official foreign exchange market intervention
aimed at moderating the rate of change and
preventing undue fluctuations in the exchange
rate, rather than at establishing a level for it.

Free Float
If intervention and aims to address disorderly
market conditions.

And if the authorities have provided info / Data
confirming that intervention has been limited to
three instances at most during the previous six
months, each lasting no more than three business
days.

If the info / Data required are not available to the
IMF staff, the arrangement is classified as floating.

Exchange rate arrangements 1998 2009
Hard pegs 23 23
Currency board 13 13
Arrange with no separate legel tender 10 10
Soft pegs 81 78
Conventional peg 68 46
Peg-like arrangement - 21
Pegged exchange rate with horizontal
bands
3 3
Crawling peg 8 5
Crawling band 2 -
Crawl-like arrangement - 3
Floating Arrangements 84 75
Managed float 44 40
Independent float 40 -
Free float - 35
Residual - 12
Total 188 188
ARGUMENTS FOR THE
FLOATING EXCHANGE RATE
SYSTEM

Under the fixed exchange rate system the monetary
authority is constrained from expanding its money supply
by the need to maintain exchange rate parity.
Increase in money supply leads to inflation
Contraction in money supply causes interest rate to be high
in order to reduce demand for money.
Under Floating exchange rate the use of monetary policy
instruments enable the government to meet desired goal.
(eg: an increase in money supply to stimulate domestic
demand and reduce unemployment does not interfere with
the need to maintain exchange rate parity)
The government can reduce money supply without an
adverse impact on exchange parity

Monetary policy autonomy

Help to ensure the independence of trade
policies
A rapid growth in the money supply will trend to
raise domestic price and lower interest rate in
short run
It cause a deficit in the current account and latter
in capital account
A flexible rate limited in balance of trade for a
certain period of time
A depreciation of currency help the balance of
trade only if it reduce the relative price of locally
produced goods
In long run it will lead to rise the cost of living.

Trade policy
independence
Flexible exchange rate help to reduce trade
imbalance
In fixed rate system a recession is required to
reduce real income or price in the event of a
trade deficit
In flexible rate only reduce the foreign exchange
value of currency

Adjustment mechanism
Liquidity issues
In flexible exchange rate it is not required to
hold foreign reserve by RBI

The problem of insufficient foreign exchange
reserve does not exist with truly flexible rates
Import restrictions
flexible exchange rate also avoid the need for strict
import restrictions, which are costly to enforce, distort
trade and hence invite criticism and even retaliation
from trade partner countries.

Currency Convertibility

currency convertibility is an aspect of
countries exchange rate policies. It refers to the
easy with which domestic currency can be
traded for foreign currency for a particular usage
and at a given exchange rate.
The foreign exchange control measure
used by government under fixed or
floating includes
Import restrictions such as license or quota system
Restrictions on the remittance of foreign exchange
such as profits, dividend or royalty
Surrender of hard currency export earnings to the
central bank
Mandatory government approval for using a firms
retained foreign exchange earnings
Credit ceilings for foreign firms
Restrictions or prohibitions on offshore deposits or
investment of hard currencies
Use of multiple exchange rates simultaneously for
different items of balance of payment
Exchange Rate Management in
India
India was under fixed exchange rate regime till March 1992.
The exchange rate of the Rupee was determined and
adjusted by the Central Bank (Reserve Bank of India).
The Rupee was adjusted to a basket of currencies,
comprising of currencies of important trade partners of India
like US, Britain, Japan etc.
The exchange rate was determined by the government and
enforced by pegging operations (intervention in the currency
market) and exchange controls by the central bank.
Normally the rate was continuously adjusted by small margins
to adjust with changing inflation rates, international economic
changes and trade requirements. Such a system caused lots
of difficulties and complications for international traders.