1. Fixed Exchange Rate System:
It is an exchange rate system. In which the rate of currency exchange is fixed by the Government (or country’s central bank). It is also called as pegged exchange rate system as the value of local currency is linked with internationally accepted currencies or even gold. Nowadays, countries usually link their currencies to their trading partners like the United States dollar. For example, the United Arab Emirates pegs its currency, the UAE dirham, to 0.27 United States dollar. In other words, for 1 USD, one will always get 3.67 dirhams. It has been done to provide stability in the oil trade between the two countries.
Benefits
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- It ensures stability and predictability in foreign trade.
- It eliminates speculative activity.
- It reduces transaction costs of exchanging currency
Limitations
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- Too much intervention by Government
- Makes monetary policy relatively ineffective
- Leads to underground market (unofficial exchange rate market) getting established
Note: In a fixed exchange rate system, depreciation is known as devaluation. It is done deliberately by the Government to increase export competitiveness.
2. Floating Exchange Rate system:
It is an exchange rate system where in the rate is decided by market forces of demand and supply of trading currencies. In India, RBI follows a managed floating system in which there is active intervention by RBI to smoothen currency rate fluctuation within a certain band of currency exchange rate so as to support exporters and at the same time not to put strain on importers since both these have conflicting positions as far as currency exchange rates are concerned.
Benefits
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- It ensures easier movement of cross- border capital since the market forces are determining the price levels where the currencies are getting exchanged.
- It also brings in effectiveness of monetary policy since policy rates set the interest rates in the market. Based on the interest rate differentials, foreign portfolio investors bring in or pull out their investments from the local market. This movement of capital cross border has a bearing on the exchange rate. Thus, it enables smoother monetary policy transmission.
- It also provides resilience to external shocks like oil price increase since exchange rate changes according to demand and supply which act as automatic stabilisers as far as exchange rates are concerned.
Limitations
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- There is a level of uncertainty and confusion in international trade.
- It may cause destabilisation of economy as prices of imported items fluctuate frequently.
- It leads to an increase in speculative trading in currency which may lead to overvaluation of currency. This may hurt trade competitiveness of local goods in the international market.
- Inflationary effects can be triggered if there is sudden depreciation in currency since cost of import rises beyond a manageable limit.
