““Exchange rate System”Exchange rate System”

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ContentsContentsExchange Rate System.

3 Principles of Exchange Rate.

How to choose an Exchange Rate System.

Key Currency.

Major Currencies of World.

Benefits of pegging to a currency.

Basket of Currency.

SDR Basket.

Par Value.

Official Exchange Rate.

Requirement for Participants.

Devaluation, Revaluation.

Exchange Rate SystemExchange Rate System

In Choosing an Exchange Rate System a nation must decide whether toallow its currency to be determined by free market forces(Floating rates) or to be fixed (pegged) against some standard of value.

The decision to peg a currency includes option of pegging to a single Currency, to a basket of currencies or to gold.

Since 1971 the technique of expressing the official Exchange rates in terms of gold has not been used, gold has been phased out of International Monitory System.

3 Principles of Exchange Rate.

Exchange rate should not be manipulated to prevent effective balance of payment adjustments or to gain unfair competitive advantage over other members.

Member should act to counter short term disorderly conditions in Exchange Markets.

When members intervene in Exchange Markets, they should take into account the interests of other members

How to choose an Exchange Rate System.

Characteristics of Economy: -- Economy generally recognize that there is no perfect exchange rate system. What is best depends on the characteristics of a particular economy: --

Capital Mobility

Credibility of policy Makers

Degree of financial Development

Labor Market Flexibility

Inflation rate.

Size and openness of economy.

Key CurrencyKey CurrencyThe Currency traded on world money market has been widely accepted as a means of International Settlement.

Major Currency of the World: -

U.S. Dollar

German Mark

Japanese Yen

British Pound

French Franc

Swiss Franc

Neither land’s guilder.

Benefits of pegging to a currency.

•For Developing nations: - The prices of the traded products of many developing nations are determined primarily in the market of industrialized nations such as united states, by pegging say to the dollar these nations can stabilize the domestic country prices of their Export and Import.

•As united states has relatively low inflation, so by making commitment to stabilize their exchange rate against the dollar, governments hope to convince their citizen. Then they are willing to adopt the responsible monitory policies neces.sary to achieve low inflation.

Basket of Currency

Key currency in huge number are called basket of currency

or

Prescribed quantities of foreign currency.

Developing nation with more than one major trading partner often peg their currency in a group of basket of currencies.

Benefits: -

1. This pegging enables nation to average out fluctuation in Export Import prices caused by Exchange Rate Movement.

2. The effect of Exchange rate changes on the domestic economy are thus reduced.

Special Drawn RightSpecial Drawn Right

Pegging with a basket of 5 currencies establish by IMF

IMF requires that valuation of SDR basket be reviewed every 5 years. The basket is to include in proportional amounts, the currencies of the members having largest export of goods & services during the previous 5 years.

Purpose of SDR ValuationPurpose of SDR Valuation

The idea behind SDR Basket valuation is to make SDR value more stable than the foreign currency value of any single national currency

SDR BASKETCurrency AmountJapanese Yen 27.200French Franc 0.813US $ 0.582German Mark 0.446British Pound 0.105

Par Value

When a currency is valued in terms of gold or a key currency called the par value of that currency.

Official Exchange Rate

By comparing the par values of two currencies we can determine their official Exchange rate.

For Example:- Official Exchange Rate between U.S.Dollar and British pound was $ 2.80=1British pound as long as the united states bought and sold gold at a fixed price of $ 35 per ounce and Britain bought and sold gold British pound 12.50 per ounce (35.00/12.50) =2.80

Now a days instead of gold Countries choose key currencies to define the par value such as U.S.Dollar.

For Example: - Bolivian Central bankers fix their peso at 20 pesos = US$ 1 and Ecuador is sucre is set at 10 sucres = US $ 1 the Official Exchange rate between peso and sucre become 1 Peso = 0.5 sucre

Requirement for Participants

1. To determine an official exchange rate for its currency.

2. To set up an exchange stabilization fund to defend the official rate. (Through Purchase and Sale of Foreign currency the Exchange stabilization fund attempt to ensure that market exchange rate does not move above or below the official exchange rate.)

Devaluation, RevaluationUnder a fixed Exchange rate system a nation’s monitory authority may decide to pursue the balance of payment equilibrium by devaluating or revaluating the currency.

Devaluation

The Purpose of Devaluation ‘ To cause the home currency’s exchange value to depreciate thus counter acting a payment deficit.’

By raising the home price of foreign currency a devaluation makes the home currencies exports cheaper to foreigners in terms of foreign Currency.

Revaluation

The Purpose of Revaluation “ To cause the home currency’s exchange value to appreciate thus counter acting a payment surplus.

A Revaluation discourages the home currency’s export and encourages the imports diverting expenditures from home goods to foreign goods.

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