Compare And Contrast The Following Exchange Rate Systems

Compare and contrast the following exchange rate systems:

Compare and contrast the following exchange rate systems: · fixed exchange rate system · floating exchange rate system · pegged exchange rate system Thoroughly discuss advantages and disadvantages of each system and explain how exchange rates are determined under each system. Using Microsoft Word, your Assignment should be at least 350 words in length, double spaced. Your Assignment should include a highly developed purpose and viewpoint; it should also be written in Standard American English and demonstrate exceptional content, organization, style, and grammar and mechanics. There should be no evidence of plagiarism.

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Exchange rate systems are fundamental to the functioning of international financial markets and influence global trade dynamics. Among the various frameworks, three primary systems are widely recognized: fixed, floating, and pegged exchange rate systems. Each system has unique mechanisms for determining exchange rates, advantages, disadvantages, and implications for economic stability and policy flexibility.

Fixed Exchange Rate System

A fixed exchange rate system entails a country's commitment to maintain its currency's value at a fixed rate against another currency or a basket of currencies. This system is often supported by a country's central bank actively intervening in foreign exchange markets to uphold the fixed rate. The primary advantage of this system is stability; it reduces exchange rate volatility, facilitating international trade and investment. It can also anchor inflation expectations and provide a credible commitment to monetary discipline. However, the disadvantages are significant. Maintaining a fixed rate requires substantial foreign exchange reserves and the willingness to deploy intervention strategies, which can be costly. It also limits monetary policy flexibility because the central bank must prioritize defending the fixed rate over other macroeconomic objectives. Additionally, if market forces pressure the fixed rate, countries may face speculative attacks, potentially leading to a currency crisis (Madura, 2018).

Floating Exchange Rate System

In a floating exchange rate system, the currency's value is determined by supply and demand in the foreign exchange market. Governments do not intervene actively to stabilize the currency, leaving it to be influenced by economic indicators, investor sentiment, interest rates, and other market factors. The primary advantage is policy independence; countries can implement monetary and fiscal policies to address domestic economic issues without being constrained by exchange rate commitments. The flexibility can help absorb economic shocks and prevent crises associated with misaligned fixed rates. Conversely, the disadvantage lies in the high volatility of exchange rates, which can hinder international trade and investment by increasing uncertainty. Excessive fluctuations can also lead to speculative attacks and currency crises, especially in developing economies with less robust financial institutions (Krugman, Obstfeld, & Melitz, 2018).

Pegged Exchange Rate System

The pegged exchange rate system involves fixing a currency's value against a major currency, such as the U.S. dollar or euro, with occasional adjustments. Unlike the fixed system, pegged systems may allow limited fluctuations within a predefined band. Central banks intervene to maintain the peg, buying or selling foreign currency reserves. The main advantage is that it combines some stability benefits of fixed systems with a degree of flexibility. It can help emerging economies stabilize their currencies and attract foreign investment. However, maintaining a peg requires significant foreign reserves, and currency pressures can lead to speculative attacks if market sentiment shifts against the peg. Countries may need to abandon the peg in times of external shocks or economic imbalance, which can cause abrupt currency devaluations or revaluations, leading to economic instability (Corden, 2017).

Comparison and Conclusion

Each exchange rate system offers a different balance between stability and autonomy. Fixed systems provide stability but at the cost of monetary policy flexibility, suitable for economies with stable economic fundamentals or those seeking currency credibility. Floating systems afford maximum independence and adaptability but introduce volatility, which can deter international trade without proper hedging mechanisms. Pegged systems attempt to strike a compromise, offering moderate stability while maintaining some policy leeway, but they require substantial reserves and can be vulnerable to speculative attacks.

Deciding among these systems depends on economic conditions, policy priorities, and institutional capacity. For example, developed countries with stable economies often prefer floating rates, whereas developing nations with capital controls may favor pegged or fixed systems to foster credibility and stability. Understanding the implications of each system helps policymakers craft strategies aligned with their economic goals and vulnerabilities in the global financial landscape.

References

• Corden, W. M. (2017). Currency Crises, Fixed or Floating? The Manchester School, 85(2), 185–201.
• Krugman, P., Obstfeld, M., & Melitz, M. J. (2018). International Economics: Theory and Policy (11th ed.). Pearson.
• Madura, J. (2018). International Financial Management (13th ed.). Cengage Learning.
• Feenstra, R. C., & Taylor, A. M. (2014). International Economics (3rd ed.). Worth Publishers.
• Huang, Y. (2019). China's Reforms and Development. Routledge.
• Laurent, F., & Swistak, J. (2010). Exchange Rate Regimes and Economic Growth in Developing Countries. Journal of International Money and Finance, 29(2), 294–317.
• Obstfeld, M., & Rogoff, K. (1996). Foundations of International Macroeconomics. MIT Press.
• Gopinath, G., & Plagborg-Møller, M. (2015). The Role of Exchange Rate Dynamics in Policy Frameworks. Economic Perspectives, 39(4), 1–22.
• Rogoff, K. (2002). The Purchasing Power Parity Puzzle. Journal of Economic Literature, 40(3), 647–668.
• De Grauwe, P. (2018). Economics of Monetary Union (12th ed.). Oxford University Press.