Broadly speaking, there can be two types of exchange rate systems; (a) fixed exchange rate system; and (b) flexible exchange rate system.
1. Fixed Exchange rate system:
Fixed exchange rate system is a system where the rate of exchange between two or more countries does not vary or varies only within narrow limits.
Under the fixed or stable exchange rate system, the government of a country adjusts its economic policies in such a manner that a stable exchange rate is maintained; it is a system of changing lock to the key.
In the strict sense, fixed exchange rate system refers to the international gold standard (as existed before 1914) under which the countries define their currencies in gold at a ratio assumed .to be fixed indefinitely.
But, in modern times, the fixed exchange rate system is identified with adjustable peg system of the International Monetary Fund (IMF) under which the exchange rate is determined by the government and enforced through pegging operations or through some exchange controls.
2. Flexible Exchange Rate System:
Flexible or free exchange rate system, on the other hand, is a system where the value of one currency in terms of another is free to fluctuate and establish its equilibrium level in the exchange market through the forces of demand and supply.
Under the flexible exchange rate system, the rate of exchange is allowed to vary to suit the economic policies of the government; it is a system of changing key to the lock. The flexible exchange rates are determined by the forces of demand and supply in the exchange market.
There are no restrictions on the buying and selling of the foreign currencies by the monetary authority and the exchange rates are free to change according to the changes in the demand and supply of foreign exchange.