This article looks at the different methods of foreign exchange rates valuation used by global countries.
When the Bretton Woods foreign exchange rates valuation system was stopped, the global community made the decision to accept floating rates. When this occurred, the gold system was removed permanently. This does not imply that all governments were willing to accept a floating rate system only. You still find governments that make use of different systems and the choice they have today is:
The floating foreign exchange rates system is based purely on supply and demand. This means that the country’s exchange rate value will fluctuate on a regular basis. In cases where the value drops or rises sharply, it is possible for the central bank to take intervention steps to curb the movement. If the currency falls to a level below that which is acceptable to the central bank, it may make the decision to increase the short-term interest rate. A higher interest rate is an attraction for investors which means the demand for the currency will increase. This will increase the value of the currency. Increasing the interest rate is one of the simple methods of adjusting the rate. Central banks have several other methods that they make use of for this purpose.
Fixed Foreign Exchange Rates
Some countries make the decision to fix its exchange rate to that of one of the major currencies. This is a method used to offer the country stability rather than using a floating rate. Some countries may choose a handful of foreign currencies to peg to. In this case, the country’s exchange rate fluctuates in line with the currencies it is pegged to.
This occurs when a country makes the decision to adopt another country’s currency. The system is ideal for developing countries as it gives the perceived idea of a stable economy. There are several benefits to the adoptive country, but there are also pitfalls with this system. The main pitfall of this type of system is that the adoptive country’s central bank no longer has control over its monetary policy and the supply of money.
There are countries that do not choose a single system. It would normally opt for a combination of a fixed and a floating system. The fixed rates would only apply to specific sections of the market, such as essential goods and current account transactions. This indicates that capital account transactions would make use of the floating rate system. This method of valuation is done to smooth the flow of transactions. Capital account transactions are done to maintain the required levels of foreign reserves in a country.
The concepts of the two systems remain the same in those countries that make use of dual systems. The only difference is that the markets are separated into various segments each making use of its own foreign exchange rate, either fixed or floating. This method is used when a country has experienced a shock to its economic climate. The dual system is then implemented by the government as a method of intervention for the alleviation of the extra pressure that is placed on its foreign reserves.
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