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Exchange rate-

Infinance,an exchange rate(also known as a foreign-exchange rate, forex rate, FX rateorAgio)between twocurrenciesis the rate at which one currency will be exchanged for another. It

is also regarded as the value of one countrys currency in terms of another currency.[1]

Forexample, an interbank exchange rate of 91Japanese yen(JPY, ) to theUnited States dollar(US$) means that 91 will be exchanged for each US$1 or that US$1 will be exchanged for each91. Exchange rates are determined in theforeign exchange market,[2]which is open to a widerange of different types of buyers and sellers where currency trading is continuous: 24 hours aday except weekends, i.e. trading from 20:15GMTon Sunday until 22:00 GMT Friday. Thespot exchange raterefers to the current exchange rate. Theforward exchange raterefers to anexchange rate that is quoted and traded today but for delivery and payment on a specific futuredate.

In the retail currency exchange market, a different buying rateand selling ratewill be quoted

by money dealers. Most trades are to or from the local currency. The buying rate is the rate atwhich money dealers will buy foreign currency, and the selling rate is the rate at which they willsell the currency. The quoted rates will incorporate an allowance for a dealer's margin (or profit)in trading, or else the margin may be recovered in the form of a "commission" or in some otherway. Different rates may also be quoted for cash (usually notes only), a documentary form (suchastraveler's cheques)or electronically (such as a credit card purchase). The higher rate ondocumentary transactions is due to the additional time and cost of clearing the document, whilethe cash is available for resale immediately. Some dealers on the other hand prefer documentarytransactions because of the security concerns with cash.

Retail exchange market

People may need to exchange currencies in a number of situations. For example, peopleintending to travel to another country may buy foreign currency in a bank in their home country,where they may buy foreign currency cash, traveler's cheques or a travel-card. From a localmoney changer they can only buy foreign cash. At the destination, the traveler can buy localcurrency at the airport, either from a dealer or through an ATM. They can also buy localcurrency at their hotel, a local money changer, through an ATM, or at a bank branch. When theypurchase goods in a store and they do not have local currency, they can use a credit card, whichwill convert to the purchaser's home currency at its prevailing exchange rate. If they havetraveler's cheques or a travel card in the local currency, no currency exchange is necessary. Then,if a traveler has any foreign currency left over on their return home, they may want to sell it,

which they may do at their local bank or money changer. The exchange rate as well as fees andcharges can vary significantly on each of these transactions, and the exchange rate can vary fromone day to the next.

There are variations in the quoted buying and selling rates for a currency between foreignexchange dealers and forms of exchange, and these variations can be significant. For example,consumer exchange rates used byVisaandMasterCardoffer the most favorable exchange ratesavailable, according to a Currency Exchange Study conducted byCardHub.com.[3]This studied
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consumer banks in the U.S., andTravelex,showed that the credit card networks save travelersabout 8% relative to banks and roughly 15% relative to airport companies.[3]

Quotations

Exchange rates display in ThailandMain article:Currency pair

A currency pair is the quotation of the relative value of a currency unit against the unit of anothercurrency in the foreign exchange market. The quotation EUR/USD 1.3533 means that 1 Euro isable to buy 1.3533 US dollar. In other words, this is the price of a unit of Euro in US dollar.Here, EUR is called the "Fixed currency", while USD is called the "Variable currency".

There is a market convention that determines which is the fixed currency and which is thevariable currency. In most parts of the world, the order is: EURGBPAUDNZDUSDothers. Accordingly, a conversion from EUR to AUD, EUR is the fixed currency, AUD is thevariable currency and the exchange rate indicates how many Australian dollars would be paid orreceived for 1 Euro. Cyprus and Malta which were quoted as the base to the USD and otherswere recently removed from this list when they joined theEurozone.
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In some areas of Europe and in the non-professional market in the UK, EUR and GBP arereversed so that GBP is quoted as the base currency to the euro. In order to determine which isthe base currency where both currencies are not listed (i.e. both are "other"), market conventionis to use the base currency which gives an exchange rate greater than 1.000. This avoidsrounding issues and exchange rates being quoted to more than four decimal places. There are

some exceptions to this rule, for example, the Japanese often quote their currency as the base toother currencies.

Quotes using a country's home currency as the price currency (for example, EUR 0.735342 =USD 1.00 in the Eurozone) are known as direct quotation or price quotation (from that country'sperspective)[4]and are used by most countries.

Quotes using a country's home currency as the unit currency (for example, USD 1.35991 = EUR1.00 in the Eurozone) are known as indirect quotation or quantity quotation and are used inBritishnewspapers and are also common inAustralia,New Zealandand the Eurozone.

Using direct quotation, if the home currency is strengthening (that is,appreciating,or becomingmore valuable) then the exchange rate number decreases. Conversely, if the foreign currency isstrengthening, the exchange rate number increases and the home currency isdepreciating.

Market convention from the early 1980s to 2006 was that most currency pairs were quoted tofour decimal places for spot transactions and up to six decimal places for forward outrights orswaps. (The fourth decimal place is usually referred to as a "pip"). An exception to this wasexchange rates with a value of less than 1.000 which were usually quoted to five or six decimalplaces. Although there is not any fixed rule, exchange rates with a value greater than around 20were usually quoted to three decimal places and currencies with a value greater than 80 werequoted to two decimal places. Currencies over 5000 were usually quoted with no decimal places

(for example, the former Turkish Lira). e.g. (GBPOMR : 0.765432 - : 1.4436 - EURJPY :165.29). In other words, quotes are given with five digits. Where rates are below 1, quotesfrequently include five decimal places.

In 2005, Barclays Capital broke with convention by offering spot exchange rates with five or sixdecimal places on their electronic dealing platform.[5]The contraction of spreads (the differencebetween the bid and offer rates) arguably necessitated finer pricing and gave the banks the abilityto try and win transaction on multibank trading platforms where all banks may otherwise havebeen quoting the same price. A number of other banks have now followed this system.

Exchange rate regime

Main article:Exchange rate regime

Each country, through varying mechanisms, manages the value of its currency. As part of thisfunction, it determines theexchange rate regimethat will apply to its currency. For example, thecurrency may be free-floating, pegged or fixed, or a hybrid.
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If a currency is free-floating, its exchange rate is allowed to vary against that of other currenciesand is determined by the market forces of supply and demand. Exchange rates for suchcurrencies are likely to change almost constantly as quoted onfinancial markets,mainly bybanks,around the world.

A movable or adjustable peg system is a system offixed exchange rates,but with a provision forthe revaluation (usually devaluation) of a currency. For example, between 1994 and 2005, theChinese yuan renminbi(RMB) was pegged to theUnited States dollarat RMB 8.2768 to $1.China was not the only country to do this; from the end ofWorld War IIuntil 1967, WesternEuropean countries all maintained fixed exchange rates with the US dollar based on theBrettonWoods system.[1]But that system had to be abandoned in favor of floating, market-basedregimes due to market pressures and speculations in the 1970s.

Still, some governments strive to keep their currency within a narrow range. As a result,currencies becomeover-valuedor under-valued, leading to excessive trade deficits or surpluses.

Fluctuations in exchange rates

A market-based exchange rate will change whenever the values of either of the two componentcurrencies change. A currency will tend to become more valuable whenever demand for it isgreater than the available supply. It will become less valuable whenever demand is less thanavailable supply (this does not mean people no longer want money, it just means they preferholding their wealth in some other form, possibly another currency).

Increased demand for a currency can be due to either an increased transactiondemand for moneyor an increased speculative demand for money. The transaction demand is highly correlated to acountry's level of business activity, gross domestic product (GDP), and employment levels. The

more people that areunemployed,the less the public as a whole will spend on goods andservices.Central bankstypically have little difficulty adjusting the available money supply toaccommodate changes in the demand for money due to business transactions.

Speculative demand is much harder for central banks to accommodate, which they influence byadjustinginterest rates.A speculator may buy a currency if the return (that is the interest rate) ishigh enough. In general, the higher a country's interest rates, the greater will be the demand forthat currency. It has been argued[

by whom?]that such speculation can undermine real economicgrowth, in particular since large currency speculators may deliberately create downward pressureon a currency by shorting in order to force that central bank to buy their own currency to keep itstable. (When that happens, the speculator can buy the currency back after it depreciates, close

out their position, and thereby take a profit.)[citation needed]

Forcarrier companiesshipping goods from one nation to another, exchange rates can oftenimpact them severely. Therefore, most carriers have aCAFcharge to account for thesefluctuations.[6][7]

Purchasing power of currency
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The real exchange rate(RER) is the purchasing power of a currency relative to another atcurrent exchange rates and prices. It is the ratio of the number of units of a given country'scurrency necessary to buy a market basket of goods in the other country, after acquiring the othercountry's currency in the foreign exchange market, to the number of units of the given country'scurrency that would be necessary to buy that market basket directly in the given country .

Thus the real exchange rate is the exchange rate times the relative prices of a market basket ofgoods in the two countries. For example, the purchasing power of theUS dollarrelative to that oftheeurois the dollar price of a euro (dollars per euro) times the euro price of one unit of themarket basket (euros/goods unit) divided by the dollar price of the market basket (dollars pergoods unit), and hence is dimensionless. This is the exchange rate (expressed as dollars per euro)times the relative price of the two currencies in terms of their ability to purchase units of themarket basket (euros per goods unit divided by dollars per goods unit). If all goods were freelytradable,and foreign and domestic residents purchased identical baskets of goods,purchasingpower parity(PPP) would hold for the exchange rate andGDP deflators(price levels) of the twocountries, and the real exchange rate would always equal 1.

The rate of change of this real exchange rate over time equals the rate of appreciation of the euro(the positive or negative percentage rate of change of the dollars-per-euro exchange rate) plus theinflation rateof the euro minus the inflation rate of the dollar.

Bilateral vs. effective exchange rate

Example of GNP-weighted nominal exchange rate history of a basket of 6 important currencies(US Dollar, Euro, Japanese Yen, Chinese Renminbi, Swiss Franks, Pound Sterling

Bilateral exchange rate involves a currency pair, while aneffective exchange rateis a weightedaverage of a basket of foreign currencies, and it can be viewed as an overall measure of the

country's external competitiveness. A nominal effective exchange rate (NEER) is weighted withthe inverse of the asymptotic trade weights. A real effective exchange rate (REER) adjustsNEER by appropriate foreign price level and deflates by the home country price level. Comparedto NEER, a GDP weighted effective exchange rate might be more appropriate considering theglobal investment phenomenon.

Uncovered interest rate parity
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See also:Interest rate parity#Uncovered interest rate parity

Uncovered interest rate parity(UIRP) states that an appreciation or depreciation of one currencyagainst another currency might be neutralized by a change in the interest rate differential. If USinterest rates increase while Japanese interest rates remain unchanged then the US dollar should

depreciate against the Japanese yen by an amount that preventsarbitrage(in reality the opposite,appreciation, quite frequently happens in the short-term, as explained below). The futureexchange rate is reflected into the forward exchange rate stated today. In our example, theforward exchange rateof the dollar is said to be at a discount because it buys fewer Japanese yenin the forward rate than it does in thespot rate.The yen is said to be at a premium.

UIRP showed no proof of working after the 1990s. Contrary to the theory, currencies with highinterest rates characteristically appreciated rather than depreciated on the reward of thecontainment ofinflationand a higher-yielding currency.

Balance of payments model

Thebalance of paymentsmodel holds that foreign exchange rates are at an equilibrium level ifthey produce a stablecurrent accountbalance. A nation with atrade deficitwill experience areduction in itsforeign exchange reserves,which ultimately lowers (depreciates) the value of itscurrency. A cheaper (undervalued) currency renders the nation's goods (exports) more affordablein the global market while making imports more expensive. After an intermediate period,imports will be forced down and exports to rise, thus stabilizing the trade balance and bring thecurrency towards equilibrium.

Likepurchasing power parity,the balance of payments model focuses largely on trade-ablegoods and services, ignoring the increasing role of global capital flows. In other words, money is

not only chasing goods and services, but to a larger extent, financial assets such asstocksandbonds.Their flows go into thecapital accountitem of the balance of payments, thus balancingthe deficit in the current account. The increase in capital flows has given rise to the asset marketmodel effectively.

Asset market model

See also:Capital asset pricing modelandNet Capital Outflow

The increasing volume of trading of financial assets (stocks and bonds) has required a rethink of

its impact on exchange rates. Economic variables such aseconomic growth,inflationandproductivityare no longer the only drivers of currency movements. The proportion of foreignexchange transactions stemming from cross border-trading of financial assets has dwarfed theextent of currency transactions generated from trading in goods and services.[8]

The asset market approach views currencies as asset prices traded in an efficient financialmarket. Consequently, currencies are increasingly demonstrating a strongcorrelationwith othermarkets, particularlyequities.
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Like thestock exchange,money can be made (or lost) on trading by investors and speculators intheforeign exchange market.Currencies can be traded at spot andforeign exchange optionsmarkets. Thespot marketrepresents current exchange rates, whereas options arederivativesofexchange rates.

Manipulation of exchange rates

A country may gain an advantage ininternational tradeif itmanipulates the marketfor itscurrency to artificially keep its value low, typically by the nationalcentral bankengaging inopenmarket operations.It has been argued by US legislators that thePeople's Republic of Chinahasbeen acting in that way over a long period of time.[9]

In 2010, other nations, includingJapanandBrazil,attempted to devalue their currency in thehopes of reducing the cost of exports and thus bolstering their ailing economies. A low(undervalued) exchange rate lowers the price of a country's goods for consumers in othercountries but raises the price of goods, especially imported goods, for consumers in the

manipulating country.[10]

Fixed exchange rate

Afixed exchange rate,sometimes called apegged exchange rate,is also referred to as the Tagof particular Rate, which is a type ofexchange rate regimewhere acurrency's value is fixedagainst the value of another single currency, to a basket of other currencies, or to anothermeasure of value, such asgold.

A fixed exchange rate is usually used to stabilize the value of a currency against the currency it ispegged to. This makes trade and investments between the two countries easier and morepredictable and is especially useful for small economies in which external trade forms a largepart of their GDP.

It can also be used as a means to controlinflation.However, as the reference value rises andfalls, so does the currency pegged to it. In addition, according to theMundellFleming model,with perfectcapitalmobility, a fixed exchange rate prevents a government from using domesticmonetary policyin order to achievemacroeconomicstability.

There are no major economic players that use a fixed exchange rate (except the countries usingtheeuroand theChinese yuan). The currencies of the countries that now use the euro are stillexisting (for old bonds).[citation needed]The rates of these currencies are fixed with respect to theeuro and to each other.[

citation needed]The most recent such country to discontinue their fixedexchange rate was thePeople's Republic of China,which did so in July 2005.[1]

Maintenance
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Typically, a government wanting to maintain a fixed exchange rate does so by either buying orselling its own currency on the open market. This is one reason governments maintain reservesof foreign currencies. If the exchange rate drifts too far below the desired rate, the governmentbuys its own currency in the market using its reserves. This places greater demand on the marketand pushes up the price of the currency. If the exchange rate drifts too far above the desired rate,

the government sells its own currency, thus increasing its foreign reserves.

Another, less used means of maintaining a fixed exchange rate is by simply making it illegal totrade currency at any other rate. This is difficult to enforce and often leads to ablack marketinforeign currency. Nonetheless, some countries are highly successful at using this method due togovernment monopolies over all money conversion. This was the method employed by theChinese government to maintain a currency peg or tightly banded float against the US dollar.Throughout the 1990s, China was highly successful at maintaining a currency peg using agovernment monopoly over all currency conversion between the yuan and other currencies.[2][3]

On 6 September 2011, the Swiss National Bank imposed a franc ceiling, for the first time in

three decades, against the euro. In 1978 a franc ceiling was set versus theDeutsche Markto stemcurrency gains.

Criticisms

The main criticism of a fixed exchange rate is that flexible exchange rates serve to adjust thebalance of trade.[4]When a trade deficit occurs, there will be increased demand for the foreign(rather than domestic) currency which will push up the price of the foreign currency in terms ofthe domestic currency. That in turn makes the price of foreign goods less attractive to thedomestic market and thus pushes down the trade deficit. Under fixed exchange rates, thisautomatic rebalancing does not occur.

Governments also have to invest many resources in getting the foreign reserves to pile up inorder to defend the pegged exchange rate. Moreover a government, when having a fixed ratherthan dynamic exchange rate, cannot use monetary or fiscal policies with a free hand. Forinstance, by using reflationary tools to set the economy rolling (by decreasing taxes and injectingmore money in the market), the government risks running into a trade deficit. This might occuras the purchasing power of a common household increases along with inflation, thus makingimports relatively cheaper.

Additionally, the stubbornness of a government in defending a fixed exchange rate when in atrade deficitwill force it to use deflationary measures (increased taxation and reduced

availability of money), which can lead tounemployment.Finally, other countries with a fixedexchange rate can also retaliate in response to a certain country using the currency of theirs indefending their exchange rate.

Fixed exchange rate regime versus capital control
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The belief that the fixed exchange rate regimebrings with it stability is only partly true, sincespeculative attackstend to target currencies with fixed exchange rate regimes, and in fact, thestability of the economic system is maintained mainly throughcapital control.A fixed exchangerate regime should be viewed as a tool in capital control.

Literature

Tiwari, Rajnish (2003):Post-Crisis Exchange Rate Regimes in Southeast Asia, SeminarPaper, University of Hamburg. (PDF)

Fixed or Flexible?

Getting the Exchange Rate Right in the 1990s[5]

Fixed exchange rate system-A fixed exchange-rate system, also known as a pegged exchange rate system, is a currency system in

which governments try to maintain their currency value constant against one another.[1]

In a fixed

exchange-rate system, a countrys government decides the worth of its currency in terms of either a

fixed weight of gold, a fixed amount ofanother currencyor a basket of other currencies. Thecentral

bankof a country remains committed at all times to buy and sell its currency at a fixed price. The central

bank provides foreign currency needed to financepayments imbalances.

HistoryThegold standardor gold exchange standard of fixedexchange ratesprevailed from about 1870to 1914, before which many countries followedbimetallism.[3]The period between the two worldwars was transitory, with theBretton Woods systememerging as the new fixed exchange rateregime in the aftermath of World War II. It was formed with an intent to rebuild war-ravagednations after World War II through a series of currency stabilization programs andinfrastructureloans.[4]The early 1970s witnessed thebreakdown of the systemand its replacement by amixture of fluctuating and fixed exchange rates.[5]

Chronology

Timeline of the fixed exchange rate system:[6]

18801914 Classical gold standard period

April 1925 United Kingdom returns to gold standard
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October 1929 United States stock market crashes

September

1931United Kingdom abandons gold standard

July 1944 Bretton Woods conference

March 1947 International Monetary Fundcomes into being

August 1971United States suspends convertibility of dollar into goldBretton Woods system

collapses

December 1971 Smithsonian Agreement

March 1972 European snakewith 2.25% band of fluctuation allowed

March 1973 Managed float regimecomes into being

April 1978 Jamaica Accords take effect

September

1985Plaza accord

September

1992United Kingdom andItalyabandonExchange Rate Mechanism(ERM)

August 1993 European Monetary Systemallows 15% fluctuation in exchange rates

Gold standard

The earliest establishment of a gold standard was in the United Kingdom in 1821 followed byAustralia in 1852 and Canada in 1853. Under this system, the external value of all currencies wasdenominated in terms of gold with central banks ready to buy and sell unlimited quantities ofgold at the fixed price. Each central bank maintainedgold reservesas their official reserveasset.[7]For example, during the classical gold standard period (18791914), the U.S. dollarwas defined as 0.048 troy oz. of pure gold[8]

Bretton Woods system

Following the Second World War, theBretton Woods system(19441973) replaced gold withthe US$ as the official reserve asset. The regime intended to combine binding legal obligationswith multilateral decision-making through theInternational Monetary Fund(IMF). The rules ofthis system were set forth in the articles of agreement of the IMF and theInternational Bank forReconstruction and Development.The system was a monetary order intended to govern currency
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relations among sovereign states, with the 44 member countries required to establish a parity oftheir national currencies in terms of the U.S. dollar and to maintain exchange rates within 1% ofparity (a "band") by intervening in theirforeign exchange markets(that is, buying or sellingforeign money). The U.S. dollar was the only currency strong enough to meet the rising demandsfor international currency transactions, and so the United States agreed both to link the dollar to

gold at the rate of $35 per ounce of gold and to convert dollars into gold at that price.

[6]

Due to concerns about America's rapidly deterioratingpayments situationand massiveflight ofliquid capitalfrom the U.S., PresidentRichard Nixonsuspended the convertibility of the dollarinto gold on15 August 1971.In December 1971, theSmithsonian Agreementpaved the way forthe increase in the value of the dollar price of gold from $35.50 $38 an ounce. Speculationagainst the dollar in March 1973 led to the birth of the independent float, thus effectivelyterminating the Bretton Woods system.[6]

Current monetary regimes

Since March 1973, thefloating exchange ratehas been followed and formally recognised by theJamaica accord of 1978. Nations still needinternational reservesin order to intervene inforeignexchange marketsto balance short-run fluctuations in exchange rates.[6]The prevailing exchangerate regime is in fact often considered as a revival of the Bretton Woods policies, namelyBrettonWoods II.[9]

Mechanism

Fig.1: Mechanism of fixed exchange-rate system
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Under this system, the central bank first announces a fixed exchange-rate for the currency andthen agrees to buy and sell the domestic currency at this value. Themarket equilibriumexchangerate is the rate at which supply and demand will be equal, i.e., markets will clear.In a flexibleexchange rate system, this is thespot rate.In a fixed exchange-rate system, the pre-announcedrate may not coincide with the market equilibrium exchange rate. The foreign central banks

maintainreserves of foreign currenciesand gold which they can sell in order to intervene in theforeign exchange market to make up the excess demand or take up the excess supply[2]

The demand for foreign exchange is derived from the domestic demand for foreigngoods,services,and financialassets.The supply of foreign exchange is similarly derived from theforeign demand for goods, services, and financial assets coming from the home country. Fixedexchange-rates are not permitted to fluctuate freely or respond to daily changes in demand andsupply. The government fixes the exchange value of the currency. For example, theEuropeanCentral Bank(ECB) may fix its exchange rate at 1 = $1 (assuming that the euro follows thefixed exchange-rate). This is the central value orpar valueof the euro. Upper and lower limitsfor the movement of the currency are imposed, beyond which variations in the exchange rate are

not permitted. The "band" or "spread" in Fig.1 is 0.4 (from 1.2 to 0.8).

[10]

Excess demand for dollars

Fig.2: Excess demand for dollars

Fig.2 describes the excess demand for dollars. This is a situation where domestic demand forforeign goods, services, and financial assets exceeds the foreign demand for goods, services, andfinancial assets from theEuropean Union.If the demand for dollar rises from DD to D'D', excessdemand is created to the extent of cd. The ECB will sell cddollars in exchange for euros tomaintain the limit within the band. Under a floating exchange rate system, equilibrium wouldhave been achieved at e.
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When the ECB sells dollars in this manner, its official dollar reserves decline and domesticmoney supplyshrinks. To prevent this, the ECB may purchasegovernment bondsand thus meetthe shortfall in money supply. This is calledsterilized interventionin the foreign exchangemarket. When the ECB starts running out of reserves, it may also devalue the euro in order toreduce the excess demand for dollars, i.e., narrow the gap between the equilibrium and fixed

rates.

Excess supply of dollars

Fig.3: Excess supply of dollars

Fig.3 describes the excess supply of dollars. This is a situation where the foreign demand forgoods, services, and financial assets from the European Union exceeds the European demand forforeign goods, services, and financial assets. If the supply of dollars rises from SS to S'S', excesssupply is created to the extent of ab. The ECB will buy abdollars in exchange for euros tomaintain the limit within the band. Under a floating exchange rate system, equilibrium wouldagain have been achieved at e.

When the ECB buys dollars in this manner, its official dollar reserves increase and domesticmoney supplyexpands, which may lead to inflation. To prevent this, the ECB may sell

government bonds ans thus counter the rise in money supply.

When the ECB starts accumulating excess reserves, it may also revalue the euro in order toreduce the excess supply of dollars, i.e., narrow the gap between the equilibrium and fixed rates.This is the opposite ofdevaluation.
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Types of fixed exchange rate systems

The gold standard

Under the gold standard, a countrys government declares that it will exchange its currency for a

certain weight in gold. In a pure gold standard, a countrys government declares that it will freelyexchange currency for actual gold at the designated exchange rate. This "rule of exchangeallows anyone to go the central bank and exchange coins or currency for with pure gold or viceversa. The gold standard works on the assumption that there are no restrictions on capitalmovements or export of gold by private citizens across countries.

Because the central bank must always be prepared to give out gold in exchange for coin andcurrency upon demand, it must maintain gold reserves. Thus, this system ensures that theexchange rate between currencies remains fixed. For example, under this standard, a 1 goldcoin in the United Kingdom contained 113.0016 grains of pure gold, while a $1 gold coin in theUnited States contained 23.22 grains. The mint parity or the exchange rate was thus: R = $/ =

113.0016/23.22 = 4.87.[6]The main argument in favour of the gold standard is that it ties theworld price level to the world supply of gold, thus preventing inflation unless there is a golddiscovery (agold rush,for example).

Price specie flow mechanism

The automatic adjustment mechanism under the gold standard is theprice specie flowmechanism,which operates so as to correct anybalance of payments disequilibriaand adjust toshocksor changes. This mechanism was originally introduced byRichard Cantillonand laterdiscussed byDavid Humein 1752 to refute themercantilistdoctrines and emphasize that nationscould not continuously accumulate gold by exporting more than their imports.

The assumptions of this mechanism are:

1. Prices are flexible2. All transactions take place in gold3. There is a fixed supply of gold in the world4. Gold coins are minted at a fixed parity in each country5. There are no banks and no capital flows

Adjustment under a gold standard involves the flow of gold between countries resulting inequalizationof prices satisfyingpurchasing power parity,and/or equalization of rates ofreturn

on assetssatisfyinginterest rate parityat the current fixed exchange rate. Under the goldstandard, each country's money supply consisted of either gold or paper currency backed bygold. Money supply would hence fall in the deficit nation and rise in the surplus nation.Consequently, internal prices would fall in the deficit nation and rise in thesurplusnation,making the exports of the deficit nation more competitive than those of the surplus nations. Thedeficit nation's exports would be encouraged and the imports would be discouraged till thedeficit in the balance of payments was eliminated.[11]
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In brief:

Deficit nation: Lower money supply Lower internal prices More exports, less imports Elimination of deficit

Surplus nation: Higher money supply Higher internal prices Less exports, more imports Elimination of surplus

Reserve currency standard

In a reserve currency system, the currency of another country performs the functions that goldhas in a gold standard. A country fixes its own currency value to a unit of another countryscurrency, generally a currency that is prominently used in international transactions or is thecurrency of a major trading partner. For example, suppose India decided to fix its currency to thedollar at the exchange rate E/$ = 45.0. To maintain this fixed exchange rate, theReserve Bankof Indiawould need to hold dollars on reserve and stand ready to exchange rupees for dollars (or

dollars for rupees) on demand at the specified exchange rate. In the gold standard the centralbank held gold to exchange for its own currency, with a reserve currency standard it must hold astock of the reserve currency.

Currency boardarrangements are the most widespread means of fixed exchange rates. Underthis, a nation rigidly pegs its currency to a foreign currency,Special drawing rights(SDR) or abasket of currencies. The central bank's role in the country's monetary policy is thereforeminimal. CBAs have been operational in many nations like

Hong Kong(since 1983); Argentina(1991 to 2001); Estonia(1992 to 2010); Lithuania(since 1994); Bosnia and Herzegovina(since 1997); Bulgaria(since 1997); Bermuda(since 1972); Denmark(since 1945); Brunei(since 1967)[12]

Gold exchange standard

The fixed exchange rate system set up after World War II was a gold-exchange standard, as wasthe system that prevailed between 1920 and the early 1930s.[13]A gold exchange standard is amixture of a reserve currency standard and a gold standard. Its characteristics are as follows:

All non-reserve countries agree to fix their exchange rates to the chosen reserve at someannounced rate and hold a stock of reserve currency assets.

The reserve currency country fixes its currency value to a fixed weight in gold and agrees toexchange on demand its own currency for gold with other central banks within the system, upon

demand.
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Unlike the gold standard, the central bank of the reserve country does not exchange gold forcurrency with the general public, only with other central banks.

Hybrid exchange rate systems

The current state of foreign exchange markets does not allow for the rigid system of fixedexchange rates. At the same time, freely floating exchange rates expose a country tovolatilityinexchange rates. Hybrid exchange rate systems have evolved in order to combine thecharacteristics features of fixed and flexible exchange rate systems. They allow fluctuation of theexchange rates without completely exposing the currency to the flexibility of a free float.

Basket-of-currencies

Countries often have several important trading partners or are apprehensive of a particularcurrency being toovolatileover an extended period of time. They can thus choose to peg theircurrency to a weighted average of several currencies (also known as a currency basket). For

example, a composite currency may be created consisting of hundred rupees, 100 Japanese yenand one U.S. dollar the country creating this composite would then need to maintain reserves inone or more of these currencies to satisfy excess demand or supply of its currency in the foreignexchange market.

A popular and widely used composite currency is theSDR,which is a composite currencycreated by theInternational Monetary Fund(IMF), consisting of a fixed quantity of U.S. dollars,euros, Japanese yen, and British pounds.

Crawling pegs

In a crawling peg system a country fixes its exchange rate to another currency or basket ofcurrencies. This fixed rate is changed from time to time at periodic intervals with a view toeliminating exchange rate volatility to some extent without imposing the constraint of a fixedrate. Crawling pegs are adjusted gradually, thus avoiding the need forinterventionsby the centralbank (though it may still choose to do so in order to maintain the fixed rate in the event ofexcessive fluctuations).

Pegged within a band

A currency is said to be pegged within a band when thecentral bankspecifies a central exchangerate with reference to a single currency, a cooperative arrangement, or a currency composite. It

also specifies a percentage allowable deviation on both sides of this central rate. Depending onthe band width, the central bank has discretion in carrying out its monetary policy. The banditself may be a crawling one, which implies that the central rate is adjusted periodically. Bandsmay be symmetrically maintained around a crawling central parity (with the band moving in thesame direction as this parity does). Alternatively, the band may be allowed to widen graduallywithout any pre-announced central rate.
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Currency boards

Acurrency board(also known as 'linked exchange rate system")effectively replaces the centralbank through a legislation to fix the currency to that of another country. The domestic currencyremains perpetually exchangeable for thereserve currencyat the fixed exchange rate. As the

anchor currency is now the basis for movements of the domestic currency, the interest rates andinflation in the domestic economy would be greatly influenced by those of the foreign economyto which the domestic currency is tied. Thecurrency boardneeds to ensure the maintenance ofadequate reserves of the anchor currency. It is a step away from officially adopting the anchorcurrency (termed asdollarizationor euroization).

Dollarization/euroization

This is the most extreme and rigid manner of fixing exchange rates as it entails adopting thecurrency of another country in place of its own. The most prominent example is theeurozone,where 17 seventeenEuropean Union(EU)member stateshave adopted the euro () as their

common currency. Their exchange rates are effectively fixed to each other. There are similarexamples of countries adopting the U.S. dollar as their domestic currency-British Virgin Islands,Caribbean Netherlands,East Timor,Ecuador,El Salvador,Marshall Islands,Federated States ofMicronesia,Palau,Panama,Turks and Caicos Islands.

Advantages

A fixed exchange rate may minimize instabilities in real economic activity[14] Central banks can acquire credibility by fixing their country's currency to that of a more

disciplined nation[14]

On amicroeconomiclevel, a country with poorly developed orilliquidmoney marketsmay fixtheir exchange rates to provide its residents with a synthetic money market with the liquidity ofthe markets of the country that provides the vehicle currency

[14]

A fixed exchange rate reduces volatility and fluctuations in relative prices It eliminatesexchange rate riskby reducing the associated uncertainty It imposes discipline on the monetary authority International trade and investment flows between countries are facilitated Speculationin the currency markets is likely to be less destabilizing under a fixed exchange rate

system than it is in a flexible one, since it does not amplify fluctuations resulting from business

cycles

Fixed exchange rates impose a price discipline on nations with higher inflation rates than therest of the world, as such a nation is likely to face persistent deficits in itsbalance of payments

and loss of reserves

[6]

Disadvantages

The need for a fixed exchange rate regime is challenged by the emergence of sophisticatedderivatives and financial tools in recent years, which allow firms tohedgeexchange rate

fluctuations
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