Exchange Rates - Currency Systems

The choice of exchange rate regime is one of the most important that a country can
make as part of monetary policy

A free-floating currency where the external value of a currency depends

wholly on market forces of supply and demand

A managed-floating currency when the central bank may choose to

intervene in the foreign exchange markets to affect the value of a currency to
meet specific macroeconomic objectives

A fixed exchange rate system e.g. a currency peg either as part of a

currency board system or membership of the ERM II for countries intending to
join the Euro.

Free Floating Exchange Rate

The value of a currency is determined purely by demand and supply of the

currency

Trade flows and capital flows affect the exchange rate under a floating system

There is no target for the exchange rate and no intervention in the market by
the central bankSterling has floated since the UK suspended membership of
the ERM in September 1992

The Bank of England has not intervened to influence the pounds value since
it became independent in 1997
Managed Floating Exchange Rate

Value of the currency is determined by market demand for and supply of the
currency

Some currency market intervention might be considered as part of demand

management (e.g. a desire for a lower currency to boost
exports)Governments normally engage in managed floating if not part of a
fixed exchange rate system. Managed floating was a policy pursued in the UK
from 1973-1990

Semi-Fixed Exchange Rates

Exchange rate is given a specific target. The currency can move between
permitted bands of fluctuation on a day-to-day basis

Interest rates are set at a level necessary to keep the exchange rate within
target range or direct intervention in the FOREX market

Fully-Fixed Exchange Rates

The exchange rate is pegged and there are no fluctuations from the central
rate
 A country can automatically improve its competitiveness by reducing its costs
below that of other countries knowing that the exchange rate will remain
stable

Several countries operate with fixed exchange rates or currency pegs. The
Ivory Coast Franc is pegged to the Euro, with the French Treasury
guaranteeing convertibility. This facilitates exchange rate and price stability.
The peg is not threatening international competitiveness given the low
inflation rate in the Ivory Coast.

Summary of the arguments for floating and fixed exchange rate systems