Because the central bank must always be prepared to give out gold in exchange for coin and currency upon demand, it must maintain gold reserves. In the gold standard the central bank held gold to exchange for its own currency, with a reserve currency standard it must hold a stock of the reserve currency. In case of an undesired appreciation of the domestic money, the central bank buys back the foreign money and thus flushes the domestic money into the market for decreasing the demand and exchange rate. However, there is debate as to whether letting a currency float actually provides the high level of benefits that we perceive. This increases the supply of its own currency on the market.
This prevented the value of one of the currencies from fluctuating between the time the transaction was agreed upon and the time the transaction was fulfilled. Under the gold standard, each country's money supply consisted of either gold or paper currency backed by gold. Free or floating rates refer to the system where the exchange rates are determined by the conditions of demand for and supply of foreign exchange in the market. Hence if a country is growing quickly then its currency will appreciate against other currencies and if country economy is facing a downturn then its currency will depreciate against other currencies. When the balance of payments is in disequilibrium, the rate of exchange will change but the change expected can be assessed. Summary- Fixed vs Floating Exchange Rate The difference between fixed and floating exchange rate mainly depends on whether the value of a currency is controlled fixed exchange rate or allowed to be decided by the demand and supply floating exchange rate.
A means that the value of a currency doesn't change relative to another currency. In a fixed regime, market pressures can also influence changes in the exchange rate. Exporters have to deposit their foreign currencies with the central bank and importers have to request the central bank to release foreign exchange. This means that their value relative to each other and most other currencies is constantly changing with demand. Although foreign exchange rate regime reduces uncertainty in conducting foreign trade, but domestic adjustment becomes very painful and politically sensitive.
Making a decision As is the case with many investment decisions, personal choice is the dictating factor. Or in simple words, it is the value of one currency with respect to another currency. That secured credit card is like your own personal 'currency board' arrangement with the bank. Demands of the Question This is a 10 mark question that is to be written in 20 minutes. It takes a stronger system as well as a mature market to maintain a float.
In a fixed exchange-rate system, the pre-announced rate may not coincide with the market equilibrium exchange rate. The monetary co-operation does not necessarily need to be a voluntary arrangement between two countries, as it is also possible for a country to link its to another countries currency without the of the other country. Once exchange rate is fixed, supply and demand of foreign exchange is regulated by central bank of the country. In addition, developing countries with fragile currency valuation are not subject to volatile exchange rates that could ruin a delicate economy. At the same time, freely floating exchange rates expose a country to in exchange rates. Relevant cases include the Euro Area and dollarized Western Hemisphere countries like Panama and Ecuador.
Use of Foreign Currency Reserves Foreign currency reserves should be maintained to practice a fixed exchange rate regime With a floating exchange rate, foreign currency reserves can be maintained at a reduced level. This was seen in the Mexican 1995 , 1997 and Russian 1997 financial crises: an attempt to maintain a high value of the local currency to the peg resulted in the currencies eventually becoming. The times at which the interest is paid to the bond holder will also be given, and will be at various points before the bond matures and you receive your initial investment back. The currency board is legally obligated to exchange one form of the currency for the other and vice-versa. On the other hand, autonomous monetary policy is lost in this regime, since the central bank must keep intervening in the foreign exchange market to maintain the exchange rate at the officially set level.
This type of exchange rate mechanism is very useful as it provides the benefit of fixed exchange rate and flexible exchange rate. One important concept that helps explain how rates are set is the difference between a fixed and floating exchange rate. What is floating exchange rate? When currency price increases, it is called appreciation and when price decreases, it is called depreciation. Monetary co-operation is considered to promote balanced and monetary stability, but can also work counter-effectively if the member countries have strongly differing levels of. This arrangement is categorized as exchange rate co-operation. Between 1870 and 1914, there was a global fixed exchange rate. In this system, foreign central banks stand ready to buy and sell their currencies at a fixed price.
Advocates of fixed exchange rates state the following points in support of fixed exchange rates: 1. On the flipside, this makes currencies potentially more volatile unstable in value when market and other conditions change unpredictably. Advantages and disadvantages of floating rate bonds Whereas fixed rate bonds are looked to for their stability and reliability, floating rate bonds main benefit comes in the form of flexibility. Floating currency exchange rates pros vs. Unfortunately, keeping a fixed exchange rate is hard work.