Essay on Exchange Rate Systems and Historical Experience


Historically, the success or failure of different exchange rate systems has depended upon the severity of shocks with which these systems had to deal.

1. Gold Standard Era (1870-1914):

The fixed exchange rate system under gold standard operated successfully before 1914 because the world economy itself was more stable. During this stable pre-war period, even fluctuating exchange rate regimes showed stability.


2. Inter-War Period of Instability:

In the inter-war period, the economic conditions throughout the whole world were chaotic. Fixed rates broke down and the governments were forced to shift to fluctuating exchange rate system.

Empirical studies have shown that, in the inter-war period, the flexible rate system showed signs of stabilising speculation in the countries with conditions of relative macroeconomic stability and of destabilis­ing speculation in the countries with relatively disturbed conditions.

3. Adjustable Peg System (1944-1971):


In the more stable and faster growing post-war world economy, international monetary institutions proved more successful. The international financial order, called the Bretton Woods system, provided a modified gold exchange standard.

Under this system, the countries maintained adjustable pegs vis-a-vis the U.S. dollar. The U.S. took the responsibility of exchanging gold for dollars with foreign central banks at a fixed price.

A new institution, i.e., International Monetary Fund (IMF), was founded as a part of the Breton Wood system.

The adjustable peg system provided compromise between fixed and flexible exchange rate systems and was aimed at achieving the twin objectives: (a) to establish international harmony and stable exchange rates associated with the gold standard; and (b) to allow individual countries the freedom to pursue their own macroeconomic policies.


4. Collapse of Adjustable Peg System:

The post-war experience with adjustable pegged exchange snowed that there were rare changes in exchange rates among major currencies. But, the system ceased to be feasible due to the basic flaws inherent in the system itself.

It carried within itself the seeds of its own destruction. The contradictory features of the adjustable peg system were: (a) stable exchange rates; (b) autonomous national macroeconomic policies; and (c) extensive international capital movements as a result of steady growth of international trade and liberalisation of international transactions.

The nations were unwilling to dispense with the second feature and did not like to impose controls necessary to nullify the effects of the third feature. Thus, the first feature must go. Ultimately, the adjustable peg system collapsed in 1971 and was replaced by the system of managed floating rates.


5. Managed Floating Rates (after 1971):

Since 1971, the system of managed floating rates has been adopted most of the countries of the world. Under this system, the currency of a country is allowed to float on foreign change market and determine its exchange rate according to market forces.

Floating rate does not imply complete absence of official intervention. The monetary authorities may intervene to restrict the fluctuations the exchange rate within certain limits.

6. Rules for Managed Floating:


In order to avoid disorderly fluctuations in the exchange rates and allow the national intervention in accordance with some international guidelines, various formal rules have been suggested. The IMF, on two occasions, has made general statements on the subject.

The Fund issued in 1974 le Guidelines for the Management of floating Exchange Rates, and in 1977 the Text of Executive Directors Discussions of Exchange Rate Policy Surveillance. But the debate regarding the formal rules continues. At present, the discussion centers round four types of norms for behavior.

(i) Leaning against the Wind:

The basic idea here is that the central banks should intervene to resist but lot neutralise market forces. In other words, short-term exchange rate fluctuations should be reduced, but long-term trends should be dictated by the market.

(ii) Targets:

Target values should be set for various exchange rates and the authorities should then intervene so as to move exchange rates towards these targets.

(iii) Objective Indicators:

Objective indicators should be used and the countries should alter their interven­tion policies when these indicators signal the existence of substantial disequilibrium.

(iv) Reference Rates. Reference rates should be set and revised periodically at levels consistent with the international economic policies of the countries involved. The aim is not to directly reduce exchange rate fluctuations but to help prevent aggressively nationalistic intervention policies.

7. Present Position:

The present position regarding the existing exchange rate system in the world economy is that the IMF articles have been so amended as to allow the countries wide discretion in exchange practices.

The major industrial countries have managed floats relative to each other, except for the adjustable pegs of the European Monetary System. Majority of the less developed countries, on the other hand, peg to a currency or to a basket of currencies.

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