Exchange Rate System
The exchange rate system is the framework of global currency trading, whereby the value of one currency is exchanged for that of another. Exchange rates are determined by the interaction between supply and demand for currencies on a global market, which is subject to a variety of economic, political and financial influences. As such, exchange rate systems are dynamic and may shift on a day-to-day basis.
Every economy has its own currency and must decide the policies related to that currency. One of the most important decisions is the exchange rate system, yet it is also one of the most difficult ones. Exchange rate systems determine the rate at which any currency is exchanged for a foreign one in international trade and financial transactions. These systems are also critical for economic growth, monetary stability, and international trade.
The main exchange rate systems that have been used throughout history were the gold standard, the Bretton Woods fixed exchange rate system, and various forms of floating exchange rate systems, in which changes in exchange rates are determined by the market.
The gold standard was the most widespread exchange rate system from 1870 until the beginning of World War I. Under the gold standard, currency exchange was based on the amount of gold a given currency was backed by. Any country that adopted the gold standard was able to maintain fixed exchange rates for a currency, that were typical at a fixed rate to gold. The Bretton Woods fixed exchange rate system, adopted in 1944, was an attempt to prevent the detrimental currency fluctuations that were seen during the Great Depression. Under the Bretton Woods system, the US dollar was fixed to gold and all other currencies were fixed to the US dollar.
The floating exchange rate system became the main exchange rate system in the 1970’s, in which the market, rather than central banks or governments, determined the rate at which any two currencies could be exchanged. With the floating exchange rate system, exchange rates fluctuate continually, as different market and global events occur, such as unemployment figures and inflation rates.
The advantages of the floating exchange rate system are that the exchange rates are determined by the market, allowing them to reflect actual conditions and thereby allowing global domestic economies to pursue differing policies. Floating exchange rates also minimize the need for intervention from central banks and governments, allowing a nation to restore balance of payments by adjusting its domestic currency.
Disadvantages of the floating exchange rate system include the risk for highly volatile currency markets, as well as the potential for speculation. Speculation can cause destabilization in currencies, as speculators attempt to make profits from shifts in exchange rates.
In conclusion, exchange rate systems are complex and must be chosen carefully. The exchange rate system chosen will have wide-ranging effects on the economy, financial system and foreign exchange markets. For this reason, the right exchange rate system is vital to a country’s economy and should be well-thought-out.
