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Wednesday, 23 November 2011

Various exchange rate systems or Distinguish between fixed and flexible and managed exchange rates systems and discuss their merits and demerits

It has greater importance in foreign trade. When any country imports the commodity from any other country, it has to make the payment, in terms of foreign currency. The foreign exchange rate determines the prices of foreign country's currency in terms of our currency.
Now question arises that how this rate is determined? Following are the three international monetary systems which prevail in the world.

In this system countries defined their currencies in terms of a fixed amount of gold. All the countries which are on gold standard they fix the rate among themselves on gold standard. Any how in this system exchange rates between the two or more than two countries are determined by the Government of the countries.

For Example : India and Pakistan are on gold standard. The price of gold is fixed Rs. 10,000 for one gram in India and in Pakistan price is 5,000 for one gram the rate of exchange between the two countries will be fifty paisa of Pakistan equal to one rupee of India.
Such type of gold standard system was finished before the second world war. Under the new system the value of the currency is fixed by the central bank of the country.

Merits :-
1. It helps to promote the international trade.

2. It ensures the certainty.

3. It inspires confidence among the traders.

Demerits :-
1. It may create disequilibrium in a country's balance of payment.

2. Under this system currency of the country may be over valued or under valued.

The rate at which national currency freely exchanges in relation to foreign currency is called floating exchange rate.
Under this system foreign exchange rate is determined by the market force of demand and supply for foreign exchange. In this system there is no intervention of the government. Exchange rate fluctuates according the market forces. The disequilibrium in the balance of payment is automatically removed.

Example : Suppose India has an excess of imports from America. India importer will purchase the dollar to make the payment, the value of dollar will increase in terms of Indian rupee. Now the American goods will become more expensive for Indian. Bur Indian product will become cheaper for Americans. Now the exports from India to American will increase. Again the equilibrium between imports and exports will take place.

Merits :-
1. It is a self regulatory system.

2. It removes the problem of disequilibrium in the balance of payment.

Demerits :-
1. It is unpredictable.

2. It increases the cost of business.

3. Fluctuation in exchange rates makes the business risky.

Under this system currency is allowed to float on foreign exchange market but govt. may intervene from time to time in the market to keep the value of the currency at the proper level.

Merits :-
1. It is flexible rate.

2. It adjusts the balance of payment automatically.

3. It provides stable terms of trade.

4. It reduces speculation and uncertainty in exchange rates.


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