FIXED AND FLOATING EXCHANGE RATES

Fixed Exchange Rates

Fixed exchange rates refer to the system under the gold standard where the rate of exchange tends to stabilise around the mint par value. Any large variation of the rate of exchange from the mint par value would entail flow of gold into or from the country. This world has the effect of bringing the exchange rate back to the mint par value.

In present-day situation where gold standard no longer exists, fixed rates of exchange refer to maintenance of external value of the country at a predetermined level. Whenever the exchange rate differs from this level it is corrected through official intervention. For example, when IMF was instituted , every member-country was required to declare the value of the currency in terms of gold and US dollars (known as the par value). The actual market rates were allowed to fluctuate only within a narrow band of margin from this level.

The par value system was abolished with the second amendment to the articles of IMF in 1978. Still the system of fixed rates continues in many countries in the form of pegging their currencies to a major currency. For instance, countries like Chile, Egypt, Iraq and Pakistan have pegged the value of their currencies to US dollar,. That is , the values of these national currencies are fixed in terms of US dollar and are allowed to vary in the exchange markets only within a narrow band.

If the exports of the country exceed imports, the demand for the local currency in the exchange market will rise. This will raise value of the currency in the market. Where the increase in value is beyond the support point, the central bank of the country intervenes in the market to sell local currency and thus the foreign exchange reserves of the country increase. The sale of local currency in the market leads to increase in money supply in the country causing inflation. Revaluation may be resorted to allow supply for more imports and contain inflation.

If the country is facing balance deficits due to higher imports, it would have the effect of increase in supply of local currency in the foreign exchange markets. The police of local currency may go below the support point and the central bank may have to intervene by buying local currency at a higher price. In the process, the foreign reserves of the country are depleted because the foreign currencies are exchanged in the market for buying local, currency. To make up for the deficit, the country may be compelled to devalue the currency. The large scale buying of local currency will reduce the domestic money supply and may help fight inflation.

Under fixed rates, the compulsion to devalue the currency may be postponed or avoided by mopping up additional reserves. One such way is exchange of currency reserves between the central banks of countries. For instance, if India is in deficit, reserve bank may sell rupees to bank of England against purchase of pound sterling. The sale will be reserved after a number of years when India has corrected its balance of payments.