Exchange rateIn finance, an exchange rate (also known as a foreign-exchange rate, forex rate, FX rate or Agio) between two

currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one countrys currency in terms of another currency.[1] For example, an interbank exchange rate of 91 Japanese yen (JPY, ) to the United States dollar (US$) means that 91 will be exchanged for each US$1 or that US$1 will be exchanged for each 91. Exchange rates are determined in the foreign exchange market,[2] which is open to a wide range of different types of buyers and sellers where currency trading is continuous: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date. In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer's margin (or profit) in trading, or else the margin may be recovered in the form of a "commission" or in some other way. Different rates may also be quoted for cash (usually notes only), a documentary form (such as traveler's cheques) or electronically (such as a credit card purchase). The higher rate on documentary transactions is due to the additional time and cost of clearing the document, while the cash is available for resale immediately. Some dealers on the other hand prefer documentary transactions because of the security concerns with cash.

Retail exchange market

People may need to exchange currencies in a number of situations. For example, people intending to travel to another country may buy foreign currency in a bank in their home country, where they may buy foreign currency cash, traveler's cheques or a travel-card. From a local money changer they can only buy foreign cash. At the destination, the traveler can buy local currency at the airport, either from a dealer or through an ATM. They can also buy local currency at their hotel, a local money changer, through an ATM, or at a bank branch. When they purchase goods in a store and they do not have local currency, they can use a credit card, which will convert to the purchaser's home currency at its prevailing exchange rate. If they have traveler's cheques or a travel card in the local currency, no currency exchange is necessary. Then, if a traveler has any foreign currency left over on their return home, they may want to sell it, which they may do at their local bank or money changer. The exchange rate as well as fees and charges can vary significantly on each of these transactions, and the exchange rate can vary from one day to the next. There are variations in the quoted buying and selling rates for a currency between foreign exchange dealers and forms of exchange, and these variations can be significant. For example, consumer exchange rates used by Visa and MasterCard offer the most favorable exchange rates available, according to a Currency Exchange Study conducted by CardHub.com.[3] This studied

consumer banks in the U.S., and Travelex, showed that the credit card networks save travelers about 8% relative to banks and roughly 15% relative to airport companies.[3]

Quotations

Exchange rates display in Thailand Main article: Currency pair A currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The quotation EUR/USD 1.3533 means that 1 Euro is able to buy 1.3533 US dollar. In other words, this is the price of a unit of Euro in US dollar. Here, EUR is called the "Fixed currency", while USD is called the "Variable currency". There is a market convention that determines which is the fixed currency and which is the variable currency. In most parts of the world, the order is: EUR GBP AUD NZD USD others. Accordingly, a conversion from EUR to AUD, EUR is the fixed currency, AUD is the variable currency and the exchange rate indicates how many Australian dollars would be paid or received for 1 Euro. Cyprus and Malta which were quoted as the base to the USD and others were recently removed from this list when they joined the Eurozone.

In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro. In order to determine which is the base currency where both currencies are not listed (i.e. both are "other"), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than four decimal places. There are some exceptions to this rule, for example, the Japanese often quote their currency as the base to other currencies. Quotes using a country's home currency as the price currency (for example, EUR 0.735342 = USD 1.00 in the Eurozone) are known as direct quotation or price quotation (from that country's perspective)[4] and are used by most countries. Quotes using a country's home currency as the unit currency (for example, USD 1.35991 = EUR 1.00 in the Eurozone) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and the Eurozone. Using direct quotation, if the home currency is strengthening (that is, appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely, if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating. Market convention from the early 1980s to 2006 was that most currency pairs were quoted to four decimal places for spot transactions and up to six decimal places for forward outrights or swaps. (The fourth decimal place is usually referred to as a "pip"). An exception to this was exchange rates with a value of less than 1.000 which were usually quoted to five or six decimal places. Although there is not any fixed rule, exchange rates with a value greater than around 20 were usually quoted to three decimal places and currencies with a value greater than 80 were quoted to two decimal places. Currencies over 5000 were usually quoted with no decimal places (for example, the former Turkish Lira). e.g. (GBPOMR : 0.765432 - : 1.4436 - EURJPY : 165.29). In other words, quotes are given with five digits. Where rates are below 1, quotes frequently include five decimal places. In 2005, Barclays Capital broke with convention by offering spot exchange rates with five or six decimal places on their electronic dealing platform.[5] The contraction of spreads (the difference between the bid and offer rates) arguably necessitated finer pricing and gave the banks the ability to try and win transaction on multibank trading platforms where all banks may otherwise have been quoting the same price. A number of other banks have now followed this system.

Exchange rate regime

Main article: Exchange rate regime Each country, through varying mechanisms, manages the value of its currency. As part of this function, it determines the exchange rate regime that will apply to its currency. For example, the currency may be free-floating, pegged or fixed, or a hybrid.

If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world. A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the revaluation (usually devaluation) of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar at RMB 8.2768 to $1. China was not the only country to do this; from the end of World War II until 1967, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system. [1] But that system had to be abandoned in favor of floating, market-based regimes due to market pressures and speculations in the 1970s. Still, some governments strive to keep their currency within a narrow range. As a result, currencies become over-valued or under-valued, leading to excessive trade deficits or surpluses.

Fluctuations in exchange rates

A market-based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency). Increased demand for a currency can be due to either an increased transaction demand for money or an increased speculative demand for money. The transaction demand is highly correlated to a country's level of business activity, gross domestic product (GDP), and employment levels. The more people that are unemployed, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions. Speculative demand is much harder for central banks to accommodate, which they influence by adjusting interest rates. A speculator may buy a currency if the return (that is the interest rate) is high enough. In general, the higher a country's interest rates, the greater will be the demand for that currency. It has been argued[by whom?] that such speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency by shorting in order to force that central bank to buy their own currency to keep it stable. (When that happens, the speculator can buy the currency back after it depreciates, close out their position, and thereby take a profit.)[citation needed] For carrier companies shipping goods from one nation to another, exchange rates can often impact them severely. Therefore, most carriers have a CAF charge to account for these fluctuations.[6][7]

Purchasing power of currency

The real exchange rate (RER) is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the number of units of a given country's currency necessary to buy a market basket of goods in the other country, after acquiring the other country's currency in the foreign exchange market, to the number of units of the given country's currency that would be necessary to buy that market basket directly in the given country . Thus the real exchange rate is the exchange rate times the relative prices of a market basket of goods in the two countries. For example, the purchasing power of the US dollar relative to that of the euro is the dollar price of a euro (dollars per euro) times the euro price of one unit of the market basket (euros/goods unit) divided by the dollar price of the market basket (dollars per goods unit), and hence is dimensionless. This is the exchange rate (expressed as dollars per euro) times the relative price of the two currencies in terms of their ability to purchase units of the market basket (euros per goods unit divided by dollars per goods unit). If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and GDP deflators (price levels) of the two countries, and the real exchange rate would always equal 1. The rate of change of this real exchange rate over time equals the rate of appreciation of the euro (the positive or negative percentage rate of change of the dollars-per-euro exchange rate) plus the inflation rate of the euro minus the inflation rate of the dollar.

Bilateral vs. effective exchange rate

Example of GNP-weighted nominal exchange rate history of a basket of 6 important currencies (US Dollar, Euro, Japanese Yen, Chinese Renminbi, Swiss Franks, Pound Sterling Bilateral exchange rate involves a currency pair, while an effective exchange rate is a weighted average of a basket of foreign currencies, and it can be viewed as an overall measure of the country's external competitiveness. A nominal effective exchange rate (NEER) is weighted with the inverse of the asymptotic trade weights. A real effective exchange rate (REER) adjusts NEER by appropriate foreign price level and deflates by the home country price level. Compared to NEER, a GDP weighted effective exchange rate might be more appropriate considering the global investment phenomenon.

Uncovered interest rate parity

See also: Interest rate parity#Uncovered interest rate parity Uncovered interest rate parity (UIRP) states that an appreciation or depreciation of one currency against another currency might be neutralized by a change in the interest rate differential. If US interest rates increase while Japanese interest rates remain unchanged then the US dollar should depreciate against the Japanese yen by an amount that prevents arbitrage (in reality the opposite, appreciation, quite frequently happens in the short-term, as explained below). The future exchange rate is reflected into the forward exchange rate stated today. In our example, the forward exchange rate of the dollar is said to be at a discount because it buys fewer Japanese yen in the forward rate than it does in the spot rate. The yen is said to be at a premium. UIRP showed no proof of working after the 1990s. Contrary to the theory, currencies with high interest rates characteristically appreciated rather than depreciated on the reward of the containment of inflation and a higher-yielding currency.

Balance of payments model

The balance of payments model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance. A nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers (depreciates) the value of its currency. A cheaper (undervalued) currency renders the nation's goods (exports) more affordable in the global market while making imports more expensive. After an intermediate period, imports will be forced down and exports to rise, thus stabilizing the trade balance and bring the currency towards equilibrium. Like purchasing power parity, the balance of payments model focuses largely on trade-able goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. Their flows go into the capital account item of the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model effectively.

Asset market model

See also: Capital asset pricing model and Net Capital Outflow The increasing volume of trading of financial assets (stocks and bonds) has required a rethink of its impact on exchange rates. Economic variables such as economic growth, inflation and productivity are no longer the only drivers of currency movements. The proportion of foreign exchange transactions stemming from cross border-trading of financial assets has dwarfed the extent of currency transactions generated from trading in goods and services.[8] The asset market approach views currencies as asset prices traded in an efficient financial market. Consequently, currencies are increasingly demonstrating a strong correlation with other markets, particularly equities.

Like the stock exchange, money can be made (or lost) on trading by investors and speculators in the foreign exchange market. Currencies can be traded at spot and foreign exchange options markets. The spot market represents current exchange rates, whereas options are derivatives of exchange rates.

Manipulation of exchange rates

A country may gain an advantage in international trade if it manipulates the market for its currency to artificially keep its value low, typically by the national central bank engaging in open market operations. It has been argued by US legislators that the People's Republic of China has been acting in that way over a long period of time.[9] In 2010, other nations, including Japan and Brazil, attempted to devalue their currency in the hopes of reducing the cost of exports and thus bolstering their ailing economies. A low (undervalued) exchange rate lowers the price of a country's goods for consumers in other countries but raises the price of goods, especially imported goods, for consumers in the manipulating country.[10]

Fixed exchange rate

A fixed exchange rate, sometimes called a pegged exchange rate, is also referred to as the Tag of particular Rate, which is a type of exchange rate regime where a currency's value is fixed against the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold. A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable and is especially useful for small economies in which external trade forms a large part of their GDP. It can also be used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, according to the MundellFleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. There are no major economic players that use a fixed exchange rate (except the countries using the euro and the Chinese yuan). The currencies of the countries that now use the euro are still existing (for old bonds).[citation needed] The rates of these currencies are fixed with respect to the euro and to each other.[citation needed] The most recent such country to discontinue their fixed exchange rate was the People's Republic of China, which did so in July 2005.[1]

Maintenance

Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market using its reserves. This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the government sells its own currency, thus increasing its foreign reserves. Another, less used means of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This is difficult to enforce and often leads to a black market in foreign currency. Nonetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This was the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar. Throughout the 1990s, China was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the yuan and other currencies.[2][3] On 6 September 2011, the Swiss National Bank imposed a franc ceiling, for the first time in three decades, against the euro. In 1978 a franc ceiling was set versus the Deutsche Mark to stem currency gains.

Criticisms
The main criticism of a fixed exchange rate is that flexible exchange rates serve to adjust the balance of trade.[4] When a trade deficit occurs, there will be increased demand for the foreign (rather than domestic) currency which will push up the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, this automatic rebalancing does not occur. Governments also have to invest many resources in getting the foreign reserves to pile up in order to defend the pegged exchange rate. Moreover a government, when having a fixed rather than dynamic exchange rate, cannot use monetary or fiscal policies with a free hand. For instance, by using reflationary tools to set the economy rolling (by decreasing taxes and injecting more money in the market), the government risks running into a trade deficit. This might occur as the purchasing power of a common household increases along with inflation, thus making imports relatively cheaper. Additionally, the stubbornness of a government in defending a fixed exchange rate when in a trade deficit will force it to use deflationary measures (increased taxation and reduced availability of money), which can lead to unemployment. Finally, other countries with a fixed exchange rate can also retaliate in response to a certain country using the currency of theirs in defending their exchange rate.

Fixed exchange rate regime versus capital control

The belief that the fixed exchange rate regime brings with it stability is only partly true, since speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control. A fixed exchange rate regime should be viewed as a tool in capital control.

Literature

Tiwari, Rajnish (2003): Post-Crisis Exchange Rate Regimes in Southeast Asia, Seminar Paper, University of Hamburg. (PDF)

Fixed or Flexible?

Getting the Exchange Rate Right in the 1990s[5]

Fixed exchange rate systemA fixed exchange-rate system, also known as a pegged exchange rate system, is a currency system in which governments try to maintain their currency value constant against one another.[1] In a fixed exchange-rate system, a countrys government decides the worth of its currency in terms of either a fixed weight of gold, a fixed amount of another currency or a basket of other currencies. The central bank of a country remains committed at all times to buy and sell its currency at a fixed price. The central bank provides foreign currency needed to finance payments imbalances.

History
The gold standard or gold exchange standard of fixed exchange rates prevailed from about 1870 to 1914, before which many countries followed bimetallism.[3] The period between the two world wars was transitory, with the Bretton Woods system emerging as the new fixed exchange rate regime in the aftermath of World War II. It was formed with an intent to rebuild war-ravaged nations after World War II through a series of currency stabilization programs and infrastructure loans.[4] The early 1970s witnessed the breakdown of the system and its replacement by a mixture of fluctuating and fixed exchange rates.[5]
Chronology

Timeline of the fixed exchange rate system:[6]

18801914 April 1925 Classical gold standard period United Kingdom returns to gold standard

October 1929 September 1931 July 1944 March 1947 August 1971

United States stock market crashes United Kingdom abandons gold standard Bretton Woods conference International Monetary Fund comes into being United States suspends convertibility of dollar into gold Bretton Woods system collapses

December 1971 Smithsonian Agreement March 1972 March 1973 April 1978 September 1985 September 1992 August 1993 Gold standard European snake with 2.25% band of fluctuation allowed Managed float regime comes into being Jamaica Accords take effect Plaza accord

United Kingdom and Italy abandon Exchange Rate Mechanism (ERM) European Monetary System allows 15% fluctuation in exchange rates

The earliest establishment of a gold standard was in the United Kingdom in 1821 followed by Australia in 1852 and Canada in 1853. Under this system, the external value of all currencies was denominated in terms of gold with central banks ready to buy and sell unlimited quantities of gold at the fixed price. Each central bank maintained gold reserves as their official reserve asset.[7] For example, during the classical gold standard period (18791914), the U.S. dollar was defined as 0.048 troy oz. of pure gold[8]
Bretton Woods system

Following the Second World War, the Bretton Woods system (19441973) replaced gold with the US$ as the official reserve asset. The regime intended to combine binding legal obligations with multilateral decision-making through the International Monetary Fund (IMF). The rules of this system were set forth in the articles of agreement of the IMF and the International Bank for Reconstruction and Development. The system was a monetary order intended to govern currency

relations among sovereign states, with the 44 member countries required to establish a parity of their national currencies in terms of the U.S. dollar and to maintain exchange rates within 1% of parity (a "band") by intervening in their foreign exchange markets (that is, buying or selling foreign money). The U.S. dollar was the only currency strong enough to meet the rising demands for international currency transactions, and so the United States agreed both to link the dollar to gold at the rate of $35 per ounce of gold and to convert dollars into gold at that price.[6] Due to concerns about America's rapidly deteriorating payments situation and massive flight of liquid capital from the U.S., President Richard Nixon suspended the convertibility of the dollar into gold on 15 August 1971. In December 1971, the Smithsonian Agreement paved the way for the increase in the value of the dollar price of gold from $35.50 $38 an ounce. Speculation against the dollar in March 1973 led to the birth of the independent float, thus effectively terminating the Bretton Woods system.[6]
Current monetary regimes

Since March 1973, the floating exchange rate has been followed and formally recognised by the Jamaica accord of 1978. Nations still need international reserves in order to intervene in foreign exchange markets to balance short-run fluctuations in exchange rates.[6] The prevailing exchange rate regime is in fact often considered as a revival of the Bretton Woods policies, namely Bretton Woods II.[9]

Mechanism

Fig.1: Mechanism of fixed exchange-rate system

Under this system, the central bank first announces a xed exchange-rate for the currency and then agrees to buy and sell the domestic currency at this value. The market equilibrium exchange rate is the rate at which supply and demand will be equal, i.e., markets will clear. In a exible exchange rate system, this is the spot rate. In a xed exchange-rate system, the pre-announced rate may not coincide with the market equilibrium exchange rate. The foreign central banks maintain reserves of foreign currencies and gold which they can sell in order to intervene in the foreign exchange market to make up the excess demand or take up the excess supply [2] The demand for foreign exchange is derived from the domestic demand for foreign goods, services, and financial assets. The supply of foreign exchange is similarly derived from the foreign demand for goods, services, and financial assets coming from the home country. Fixed exchange-rates are not permitted to fluctuate freely or respond to daily changes in demand and supply. The government fixes the exchange value of the currency. For example, the European Central Bank (ECB) may fix its exchange rate at 1 = $1 (assuming that the euro follows the fixed exchange-rate). This is the central value or par value of the euro. Upper and lower limits for the movement of the currency are imposed, beyond which variations in the exchange rate are not permitted. The "band" or "spread" in Fig.1 is 0.4 (from 1.2 to 0.8).[10]
Excess demand for dollars

Fig.2: Excess demand for dollars

Fig.2 describes the excess demand for dollars. This is a situation where domestic demand for foreign goods, services, and financial assets exceeds the foreign demand for goods, services, and financial assets from the European Union. If the demand for dollar rises from DD to D'D', excess demand is created to the extent of cd. The ECB will sell cd dollars in exchange for euros to maintain the limit within the band. Under a floating exchange rate system, equilibrium would have been achieved at e.

When the ECB sells dollars in this manner, its official dollar reserves decline and domestic money supply shrinks. To prevent this, the ECB may purchase government bonds and thus meet the shortfall in money supply. This is called sterilized intervention in the foreign exchange market. When the ECB starts running out of reserves, it may also devalue the euro in order to reduce the excess demand for dollars, i.e., narrow the gap between the equilibrium and xed rates.
Excess supply of dollars

Fig.3: Excess supply of dollars

Fig.3 describes the excess supply of dollars. This is a situation where the foreign demand for goods, services, and financial assets from the European Union exceeds the European demand for foreign goods, services, and financial assets. If the supply of dollars rises from SS to S'S', excess supply is created to the extent of ab. The ECB will buy ab dollars in exchange for euros to maintain the limit within the band. Under a floating exchange rate system, equilibrium would again have been achieved at e. When the ECB buys dollars in this manner, its official dollar reserves increase and domestic money supply expands, which may lead to inflation. To prevent this, the ECB may sell government bonds ans thus counter the rise in money supply. When the ECB starts accumulating excess reserves, it may also revalue the euro in order to reduce the excess supply of dollars, i.e., narrow the gap between the equilibrium and xed rates. This is the opposite of devaluation.

Types of fixed exchange rate systems

The gold standard

Under the gold standard, a countrys government declares that it will exchange its currency for a certain weight in gold. In a pure gold standard, a countrys government declares that it will freely exchange currency for actual gold at the designated exchange rate. This "rule of exchange allows anyone to go the central bank and exchange coins or currency for with pure gold or vice versa. The gold standard works on the assumption that there are no restrictions on capital movements or export of gold by private citizens across countries. Because the central bank must always be prepared to give out gold in exchange for coin and currency upon demand, it must maintain gold reserves. Thus, this system ensures that the exchange rate between currencies remains fixed. For example, under this standard, a 1 gold coin in the United Kingdom contained 113.0016 grains of pure gold, while a $1 gold coin in the United States contained 23.22 grains. The mint parity or the exchange rate was thus: R = $/ = 113.0016/23.22 = 4.87.[6] The main argument in favour of the gold standard is that it ties the world price level to the world supply of gold, thus preventing ination unless there is a gold discovery (a gold rush, for example).
Price specie flow mechanism

The automatic adjustment mechanism under the gold standard is the price specie flow mechanism, which operates so as to correct any balance of payments disequilibria and adjust to shocks or changes. This mechanism was originally introduced by Richard Cantillon and later discussed by David Hume in 1752 to refute the mercantilist doctrines and emphasize that nations could not continuously accumulate gold by exporting more than their imports. The assumptions of this mechanism are:
1. 2. 3. 4. 5. Prices are exible All transactions take place in gold There is a xed supply of gold in the world Gold coins are minted at a xed parity in each country There are no banks and no capital ows

Adjustment under a gold standard involves the flow of gold between countries resulting in equalization of prices satisfying purchasing power parity, and/or equalization of rates of return on assets satisfying interest rate parity at the current fixed exchange rate. Under the gold standard, each country's money supply consisted of either gold or paper currency backed by gold. Money supply would hence fall in the deficit nation and rise in the surplus nation. Consequently, internal prices would fall in the deficit nation and rise in the surplus nation, making the exports of the deficit nation more competitive than those of the surplus nations. The deficit nation's exports would be encouraged and the imports would be discouraged till the deficit in the balance of payments was eliminated.[11]

In brief: Deficit nation: Lower money supply Lower internal prices More exports, less imports Elimination of deficit Surplus nation: Higher money supply Higher internal prices Less exports, more imports Elimination of surplus
Reserve currency standard

In a reserve currency system, the currency of another country performs the functions that gold has in a gold standard. A country fixes its own currency value to a unit of another countrys currency, generally a currency that is prominently used in international transactions or is the currency of a major trading partner. For example, suppose India decided to fix its currency to the dollar at the exchange rate E/$ = 45.0. To maintain this fixed exchange rate, the Reserve Bank of India would need to hold dollars on reserve and stand ready to exchange rupees for dollars (or dollars for rupees) on demand at the specified exchange rate. In the gold standard the central bank held gold to exchange for its own currency, with a reserve currency standard it must hold a stock of the reserve currency. Currency board arrangements are the most widespread means of fixed exchange rates. Under this, a nation rigidly pegs its currency to a foreign currency, Special drawing rights (SDR) or a basket of currencies. The central bank's role in the country's monetary policy is therefore minimal. CBAs have been operational in many nations like

Hong Kong (since 1983); Argentina (1991 to 2001); Estonia (1992 to 2010); Lithuania (since 1994); Bosnia and Herzegovina (since 1997); Bulgaria (since 1997); Bermuda (since 1972); Denmark (since 1945); Brunei (since 1967) [12]

Gold exchange standard

The fixed exchange rate system set up after World War II was a gold-exchange standard, as was the system that prevailed between 1920 and the early 1930s.[13] A gold exchange standard is a mixture of a reserve currency standard and a gold standard. Its characteristics are as follows:

All non-reserve countries agree to fix their exchange rates to the chosen reserve at some announced rate and hold a stock of reserve currency assets. The reserve currency country fixes its currency value to a fixed weight in gold and agrees to exchange on demand its own currency for gold with other central banks within the system, upon demand.

Unlike the gold standard, the central bank of the reserve country does not exchange gold for currency with the general public, only with other central banks.

Hybrid exchange rate systems

The current state of foreign exchange markets does not allow for the rigid system of fixed exchange rates. At the same time, freely floating exchange rates expose a country to volatility in exchange rates. Hybrid exchange rate systems have evolved in order to combine the characteristics features of fixed and flexible exchange rate systems. They allow fluctuation of the exchange rates without completely exposing the currency to the flexibility of a free float.
Basket-of-currencies

Countries often have several important trading partners or are apprehensive of a particular currency being too volatile over an extended period of time. They can thus choose to peg their currency to a weighted average of several currencies (also known as a currency basket) . For example, a composite currency may be created consisting of hundred rupees, 100 Japanese yen and one U.S. dollar the country creating this composite would then need to maintain reserves in one or more of these currencies to satisfy excess demand or supply of its currency in the foreign exchange market. A popular and widely used composite currency is the SDR, which is a composite currency created by the International Monetary Fund (IMF), consisting of a fixed quantity of U.S. dollars, euros, Japanese yen, and British pounds.
Crawling pegs

In a crawling peg system a country fixes its exchange rate to another currency or basket of currencies. This fixed rate is changed from time to time at periodic intervals with a view to eliminating exchange rate volatility to some extent without imposing the constraint of a fixed rate. Crawling pegs are adjusted gradually, thus avoiding the need for interventions by the central bank (though it may still choose to do so in order to maintain the fixed rate in the event of excessive fluctuations).
Pegged within a band

A currency is said to be pegged within a band when the central bank specifies a central exchange rate with reference to a single currency, a cooperative arrangement, or a currency composite. It also specifies a percentage allowable deviation on both sides of this central rate. Depending on the band width, the central bank has discretion in carrying out its monetary policy. The band itself may be a crawling one, which implies that the central rate is adjusted periodically. Bands may be symmetrically maintained around a crawling central parity (with the band moving in the same direction as this parity does). Alternatively, the band may be allowed to widen gradually without any pre-announced central rate.

Currency boards

A currency board (also known as 'linked exchange rate system")effectively replaces the central bank through a legislation to fix the currency to that of another country. The domestic currency remains perpetually exchangeable for the reserve currency at the fixed exchange rate. As the anchor currency is now the basis for movements of the domestic currency, the interest rates and inflation in the domestic economy would be greatly influenced by those of the foreign economy to which the domestic currency is tied. The currency board needs to ensure the maintenance of adequate reserves of the anchor currency. It is a step away from officially adopting the anchor currency (termed as dollarization or euroization).
Dollarization/euroization

This is the most extreme and rigid manner of fixing exchange rates as it entails adopting the currency of another country in place of its own. The most prominent example is the eurozone, where 17 seventeen European Union (EU) member states have adopted the euro () as their common currency. Their exchange rates are effectively fixed to each other. There are similar examples of countries adopting the U.S. dollar as their domestic currency- British Virgin Islands, Caribbean Netherlands, East Timor, Ecuador, El Salvador, Marshall Islands, Federated States of Micronesia, Palau, Panama, Turks and Caicos Islands.

Advantages

A fixed exchange rate may minimize instabilities in real economic activity[14] Central banks can acquire credibility by fixing their country's currency to that of a more disciplined nation [14] On a microeconomic level, a country with poorly developed or illiquid money markets may fix their exchange rates to provide its residents with a synthetic money market with the liquidity of the markets of the country that provides the vehicle currency[14] A fixed exchange rate reduces volatility and fluctuations in relative prices It eliminates exchange rate risk by reducing the associated uncertainty It imposes discipline on the monetary authority International trade and investment ows between countries are facilitated Speculation in the currency markets is likely to be less destabilizing under a fixed exchange rate system than it is in a flexible one, since it does not amplify fluctuations resulting from business cycles Fixed exchange rates impose a price discipline on nations with higher inflation rates than the rest of the world, as such a nation is likely to face persistent deficits in its balance of payments and loss of reserves [6]

Disadvantages

The need for a fixed exchange rate regime is challenged by the emergence of sophisticated derivatives and financial tools in recent years, which allow rms to hedge exchange rate uctuations

The announced exchange rate may not coincide with the market equilibrium exchange rate, thus leading to excess demand or excess supply The central bank needs to hold stocks of both foreign and domestic currencies at all times in order to adjust and maintain exchange rates and absorb the excess demand or supply Fixed exchange rate does not allow for automatic correction of imbalances in the nation's balance of payments since the currency cannot appreciate/depreciate as dictated by the market It fails to identify the degree of comparative advantage or disadvantage of the nation and may lead to inefficient allocation of resources throughout the world There exists the possibility of policy delays and mistakes in achieving external balance The cost of government intervention is imposed upon the foreign exchange market [6]