The following points highlight the three major systems of exchange-rate. The systems are: 1. Purely Floating Exchange Rates System 2. Fixed Exchange Rates System 3. Managed Exchange Rates System.
1. Purely Floating Exchange Rates System:
Under this system exchange rates are completely flexible and move up and down due to changes in the factors influencing supply and demand. And the government neither announces any official exchange rate nor takes steps to enforce it. This simply means that the relative prices of currencies are determined by purchase and sale among individuals and business firms.
Suppose the initial exchange rate between the dollar and the pound is $1.50 = £1. Now suppose at this rate Americans want to buy more of British goods. This will lead to an increase in the demand for pounds. The excess demand for pounds will bid up its price (which is equivalent to a bidding down of the price of dollar).
The exchange rate will continue to move until a new rate (i.e. a higher price of pound) say, $2.00 = £1 is established at which the quantities supplied and demanded are again in balance (i.e. at which the diminished quantity of pounds demanded is equal to the increased supply of pounds.)
ADVERTISEMENTS:
The reason is easy to find out. The rise in the price of pound in terms of dollar will raise the prices of British goods, services and financial assets, causing American demand for imports to fall. At the same time, with the dollar now cheaper, American goods will now cost less to Britishers and this will encourage Britishers to buy (import) more of American goods.
In the absence of government intervention there are likely to be enormous swings in floating exchange rates even in the short run.
2. Fixed Exchange Rates System: The Classical Gold Standard:
At the other extreme we see the existence of a system of fixed exchange rates, where governments specify exactly the rate at which dollars will be officially converted into pounds and other currencies such as Japanese yen, German marks, Swiss franc, Italian lira, and so on.
Historically, the gold standard which prevailed up to 1914 was the most-important fixed exchange rate system. Under gold standard, each country defined the value of its currency in terms of a fixed amount of gold, thereby establishing fixed exchange rates among the countries on the gold standard.
3. Managed Exchange Rates System:
ADVERTISEMENTS:
In practice, very few countries today adopt either the extreme of absolutely fixed exchange rates or that of purely floating exchange rates.
Instead, most countries follow the middle course—the middle ground of managed exchange rates, under which exchange rates are basically determined by market forces (as under purely floating exchange rate system), but governments actively participate in the foreign exchange market and frequently intervene to buy or sell currencies or change their monetary (credit) policies to affect their exchange rates.