Forex Systems
In Foreign exchange, the rate of exchange is the value at which one currency is replaced with another currency. For example, if one Kuwaiti Dinar is exchanged for Rs.148, the rate of exchange between Kuwaiti Dinar and Indian rupee is 1 KD = 148 Rupees.
The different systems of Foreign Exchange include,
1. Flexible Exchange rate system
2. Fixed Exchange rate system
3. Equilibrium rate of foreign exchange
Flexible Exchange Rate system
Flexible or floating exchange rate is an exchange rate whose value in terms of other currencies is free to fluctuate. Alternatively said, the flexible or floating exchange rate is determined under free market forces of demand and supply.
The arguments put forward in favor of flexible rates of exchange are:
1. Its monetary policy is not tied down rigidly to a certain rate of exchange to maintain which it need not resort to deflate the currency or to change wages and cost of production to encourage exports and reduce imports.
2. The balance of payments problem is automatically solved. With an unfavorable balance of payments, the external value of the currency falls. This encourages exports and discourages imports, thus bringing about equilibrium in balance of payments.
3. Since any excess demand for or excess supply of currency is removed by changes in the exchange rate, the problem of scarcity or surplus of any once currency is automatically solved.
4. The system of flexible exchange rates eliminates the need for international monetary reserves and exchange controls. This solves the problem of international liquidity automatically.
5. This system does not require the use of exchange control which is generally associated with the system of pegged rates. It is stated that pegging of exchange rates is said to have caused shortage of international liquidity.
6. The argument that flexible exchange rates lead to uncertainty and hampers international trade is not convincing. Importers and exporters are able to anticipate changes in exchange rates and protect themselves by hedging in the forward exchange market.
7. It is stated that fluctuating exchange rates discourage long-term investment. This is also wrong. The investors can never be sure of any fixed rate of exchange for decades to come.
8. Stable exchange rates are not important for a system of currency area like the sterling area. Here economic, political and social considerations have induced various countries to constitute the sterling block. Just because sterling is allowed to have flexible exchange rates, these forces cannot weaken the sterling block.
9. If the rates of exchange are kept rigidly fixed, the shocks of inflation and deflation from abroad will be transmitted to the internal economic system. Fluctuations in the rates of exchange prevent such forces.
Defects of the fluctuating foreign exchange rate system:
1. The fluctuating exchange rates add to the hazards of international trade by making the calculation of prices in terms of domestic currency difficult. This uncertainty is likely to hamper international trade.
2. If exchange rates are not fixed, traders might lose in carrying out transactions for which settlement is not to take place for sometime. They could, of course, avoid loss by buying and selling currency through the forward exchange market, but nevertheless exchange fluctuations might obstruct international trade.
3. Because of speculation about currency appreciation or depreciation, fluctuating exchange rates discourage international investment.
4. Fluctuating exchange rates encourage anticipatory dealings in foreign currencies. This speculation may cause wider fluctuations than would otherwise occur.
5. Since a fluctuating exchange rate dislocates international trade, it causes serious setback to small countries whose economic development depends mostly on foreign trade.
6. Since exchange rates are fluctuating, sometime very widely, to take advantage of a sudden turn in the rate of exchange, businessmen have to keep large cash balances. Because of this, they have to curtail investment, causing unemployment.
Fixed Exchange Rate System:
Fixed rate refers to the rate between two or more currencies which do not vary or vary only within limits. Here the country officially fixes a specific exchange rate of its currency in terms of a given foreign currency and maintains the same over a period of time.
1. There is an element of certainty as a result of which importers and exporters can calculate fairly accurately the sum they will have to pay or will receive in their own currency. Thus stable exchange rates foster growth in international trade.
2. A stable foreign exchange rate ensures a regular flow of foreign capital which is vital for the countrys economic growth.
3. A fixed rate of exchange eliminates speculative tendencies.
4. For small countries in whose economic development foreign trade plays a significant role, only if a stable rate of foreign exchange is maintained, foreign trade will flourish.
5. A fixed rate of exchange obviates the need for having large liquid assets.
6. Fixed exchange rate system protects the worlds monetary system. That is why the IMF has adopted the fixed exchange rate system.
Defects of the Fixed Exchange Rate System are:
1. It is stated that the fixed exchange rates worked well under the favorable conditions of the 19th century. Since these conditions are absent today, the smooth operation of this system is not possible.
2. Pegged rates are not permanently fixed. As such, the argument that a fixed exchange rate system encourages long-term foreign investment falls flat.
3. The shocks of inflation and deflation from abroad are transmitted to internal economic system, if the rates of exchange are kept rigidly fixed.
4. To maintain a fixed exchange rate the country may have to resort to the various measures such as deflating its currency, plunging the country with depression and unemployment.
Conclusion:
From the above discussion, it is clear that while the fixed exchange rates are not feasible, fluctuating rates are not acceptable. The exchange variations are an unsuitable and undesirable means of dealing with short-term discrepancies in the balance of payments. At the same time an absolute rigidity of exchange rates is also equally harmful.
Crawling Peg system:
In view of this, the world is heading towards a compromise between these two extremes the crawling peg exchange rate system under which the exchange rate is allowed to crawl within limits on either side of the par value.
Equilibrium Rate of Foreign Exchange:
The equilibrium rate of foreign exchange keeps the balance of payments in equilibrium over a certain period of time. Here the rate of exchange reaches a comparatively stable level. This is the most suitable rate at which no sector of the economy shows any sign of maladjustment. At the equilibrium rate the domestic currency is neither undervalued nor overvalued in terms of foreign currency. This rate does not give any artificial stimulus to either exports or imports.
Features or criteria:
1. There should be an average degree of domestic stability. For example, unemployment in a country should not be greater than unemployment outside.
2. The equilibrium rate should not offer any stimuli to or inflict any disadvantages on, foreign trade. It should remain neutral.
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