Compare And Contrast The Following Exchange Rate Syst 464490

Compare and contrast the following exchange rate systems:

Compare and contrast the following exchange rate systems: fixed exchange rate system, floating exchange rate system, and pegged exchange rate system. Thoroughly discuss the 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.

Paper For Above instruction

Exchange rate systems are vital frameworks through which countries manage and control their currency's value relative to other currencies. The three primary systems—fixed exchange rate, floating exchange rate, and pegged exchange rate—each have unique mechanisms, advantages, and disadvantages that influence global trade, economic stability, and monetary policy.

Fixed Exchange Rate System

The fixed exchange rate system is characterized by a government or central bank setting and maintaining a constant value for its currency relative to another currency or a basket of currencies. This approach offers stability, making international trade and investment more predictable. Countries employing fixed systems typically do so to promote economic stability, control inflation, and foster investor confidence. For instance, Hong Kong utilizes a fixed exchange rate system by pegging its currency to the US dollar, providing stability amidst volatile markets.

One significant advantage of fixed exchange rates is the reduction of exchange rate risk, which simplifies international transactions and encourages foreign investment. Additionally, it can help curb inflation in countries with historically unstable monetary environments. However, fixed systems are not without drawbacks. Maintaining a fixed rate may deplete a country's foreign exchange reserves if market forces exert pressure contrary to the set rate. Moreover, it limits a country's ability to use monetary policy independently, as it must align with maintaining the fixed rate. If market conditions demand a change, governments may need to devalue or revalue their currencies, often leading to economic instability.

Exchange rates under fixed systems are determined solely by the government or central bank, which intervenes in foreign exchange markets to uphold the set rate. This intervention may involve buying or selling currency reserves to adjust supply and demand dynamics and sustain the rate.

Floating Exchange Rate System

The floating exchange rate system is characterized by currency values being determined freely by the market forces of supply and demand. Governments and central banks do not intervene to stabilize currency value actively. This system allows exchange rates to fluctuate based on economic indicators, investor sentiment, and geopolitical factors. For example, the US dollar and the euro operate under predominantly floating systems.

One advantage of floating exchange rates is monetary policy independence. Countries can pursue domestic economic policies, such as controlling inflation or stimulating growth, without being constrained by maintaining a fixed rate. Additionally, currency adjustments can serve as automatic stabilizers during economic shocks, preventing severe misalignments. However, the disadvantages include heightened volatility, which can increase uncertainty for traders and investors. Sharp fluctuations may lead to currency crises, affecting economic stability and discouraging long-term investment.

Exchange rates in floating systems are determined by current market conditions—buying and selling activities by investors, speculators, and governments. Central banks may intervene occasionally, but their influence is limited compared to fixed systems.

Pegged Exchange Rate System

The pegged exchange rate system, sometimes called a currency board system, involves fixing the currency's value to another major currency (like the US dollar or euro) but with the flexibility to adjust within a predetermined band. In this approach, the central bank commits to maintaining the exchange rate within a specific range, often by intervening in foreign exchange markets when necessary. Countries like the UAE dirham are pegged to the US dollar, offering a compromise between stability and flexibility.

The advantages include stability similar to fixed systems, promoting international trade and investment. It also helps control inflation, especially in countries with historical currency instability. The main disadvantage is the potential for currency crises if market pressures become intense or if the central bank's foreign exchange reserves are insufficient to sustain the peg. Also, pegged systems require periodic adjustments, which can cause economic uncertainty and may be politically sensitive.

Exchange rates under pegged systems are determined by the central bank's intervention efforts to keep the currency within the established band. When the market approaches the limits of the band, the central bank intervenes by buying or selling currency to maintain the peg, thereby influencing supply and demand dynamics.

Conclusion

Each exchange rate system offers distinct benefits and challenges. The fixed system provides stability but lacks flexibility, potentially leading to reserves depletion. The floating system offers independence and automatic adjustment but introduces volatility that can destabilize economies. The pegged system seeks a middle ground, balancing stability with some flexibility, but it still faces risks of currency crises if market pressures intensify. Countries choose their exchange rate regime based on economic goals, stability needs, and policy priorities, recognizing that no system is universally superior. Understanding these systems is crucial for policymakers and international investors aiming to navigate the complexities of global finance effectively.

References

• Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2018). International Economics (11th ed.). Pearson.
• Salvatore, D. (2019). International Economics (13th ed.). Wiley.
• Mishkin, F. S. (2019). The Economics of Money, Banking, and Financial Markets (12th ed.). Pearson.
• Corden, W. M. (2012). Exchange Rate Systems: Fixed, Floating, and Managed. Journal of Economic Perspectives, 26(4), 173-192.
• Neely, C. J. (2005). An Introduction to Fixed and Flexible Exchange Rate Regimes. Federal Reserve Bank of St. Louis.
• Frenkel, J. A., & Goldstein, M. (2019). The Mechanics of Different Exchange Rate Regimes. International Monetary Fund.
• Ghosh, A. R., Ostry, J. D., & Tsangarides, C. G. (2018). Exchange Rate Regimes and the Stability of the International Financial System. IMF Working Paper.
• Humpage, O. F. (2010). Managing Exchange Rate Policies and Expectations. Federal Reserve Bank of Cleveland.
• Frankel, J. A. (2017). How to Stabilize the International Financial System. Princeton University Press.
• Lewis, K. (2010). Currency Regimes and Global Financial Stability. Global Policy Journal.