Exchange Rate Mechanisms

Topics: Foreign exchange market, Central bank, Monetary policy Pages: 29 (9904 words) Published: October 19, 2010
An exchange rate is the price at which one country's currency must pay in order to buy one unit of another county’s currency on the foreign exchange market. The concept of exchange rate mechanism may be explained as the technique employed by the governments in order to manage and control their respective currencies in the context of the other major currencies of the world.

There are 5 exchange rate mechanisms established which each of it is meant to be followed by government regarding to the management and determination of exchange rate in regards of the foreign exchange market and foreign currencies. These 5 exchange rate mechanisms consist of namely free float system, managed float system, target-zone arrangement system, fixed-rate system, and hybrid system.

Each system has possessed distinct features, benefits and costs. Free float system’s exchange rate is determined freely by market condition, flow of demand and supply for currency. Managed float system’s exchange rate is similar with free float system which the exchange rate is freely floating depending on market’s condition, demand and supply but the feature that differs is the involvement of central bank intervention to smooth out currency fluctuations for a managed float system.

Fixed exchange rate system’s exchange rate is pegged to a major currency of another country at a specific and fixed rate of exchange, which the exchange rate is managed from fluctuation of a certain margin percentage and maintained back to the fixed exchange rate. Target zone arrangement system is a combination of the pegged and floating exchange rate, which exchange rates is maintained within a range of fixed exchange rate. Hybrid exchange rate system is the combination of free float, managed float, and fixed exchange rate systems. Under a hybrid exchange rate system, different countries adopt different exchange rate policy depending on their economic condition and economic goals to be achieved.

The occurrence of East Asian financial crisis during year 1997 until year 1998 was due to exchange rate which is the main factor that triggered this event. The collapse of Thai Baht in the July 1997 is the main trail lighting the path which eventually lead to a currency crisis and later on changed into a financial crisis that causes economic recession in the region of East Asian. Malaysia was one of those countries involved, and actions are taken in order to cushion the impact and bring back recovery in year 1999 and 2000.

Regarding the actions taken by Malaysia’s government are such as the reassertion of national control over economic policy creation, the implementation of orthodox macroeconomic policies, the introduction of capital and currency controls on 1st September 1998, and the pegging of currency against United State on 2nd September 1998.

Fixed Exchange Rate

Fixed exchange rate mechanism is a predominant exchange rate system in the world for most of the 20th century which are from 1900’s to 1970s. A fixed exchange rate, sometimes also known as pegged exchange rate is a type of exchange rate mechanism engaged by government (central bank) in order to set and maintain the exchange rate as the official exchange rate. The exchange rate is fixed at some par value, although there is some small degree of fluctuations. A set price will be determined against a major world currency, usually is the U.S. dollar. In addition, a country’s currency is also converting directly to other major currencies such as euro and yen and the currency may also be attached to a basket of other currencies, or even to another measure of value such as precious metals like gold which it’s known as Gold Standard. The participating countries fixed the prices of their currencies in terms of a specified amount of gold because the value of gold is fairly stable over time. In summary, the value of a nation’s currency is pegged to a fixed amount of a commodity or to another currency....
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