What is exchange rate system?
An exchange rate system is a set of rules and mechanisms that govern the value of a country's currency in relation to other currencies. It determines how exchange rates are determined, fixed, or allowed to fluctuate in the international foreign exchange market.
There are three main types of exchange rate systems:
1. Fixed exchange rate system: Also known as a pegged or managed exchange rate system, this involves a government or central bank fixing the value of its currency to a specific reference currency or a basket of currencies. The exchange rate remains relatively stable and changes only when the government or central bank decides to adjust it.
2. Floating exchange rate system: This system allows the exchange rate to be determined by the forces of supply and demand in the foreign exchange market. The exchange rate fluctuates freely and is influenced by various factors such as economic conditions, interest rates, trade balances, and market expectations.
3. Managed floating exchange rate system: This is a hybrid of fixed and floating exchange rate systems. The exchange rate is allowed to fluctuate within a certain range, but the central bank intervenes in the foreign exchange market to influence the value of the currency when necessary.
The choice of exchange rate system has implications for a country's monetary policy, international trade competitiveness, foreign investment, and overall economic stability.