Exchange Rate Mechanisms

9910 Words Oct 25th, 2010 40 Pages
INTRODUCTION
An exchange rate is the price at which one country's currency must pay in order to buy one unit of another county’s currency on the foreign exchange market. The concept of exchange rate mechanism may be explained as the technique employed by the governments in order to manage and control their respective currencies in the context of the other major currencies of the world.

There are 5 exchange rate mechanisms established which each of it is meant to be followed by government regarding to the management and determination of exchange rate in regards of the foreign exchange market and foreign currencies. These 5 exchange rate mechanisms consist of namely free float system, managed float system, target-zone arrangement system,
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So, the government takes some necessary actions to maintain a fixed exchange rate and prevent it from fluctuating. For instances, central bank trades its own currency on the foreign exchange market in return for the currency to which it is pegged. If the exchange rate drops too far from the desired rate, the government will buy its own currency off the market using the foreign reserves. This will result in greater demand on the market and therefore increase the price of the currency. On the other hand, if the exchange rate rises too much above the desired rate, government will sells its own currency in the market. In summary, central banks will revalue or devalue their exchange rates when the rates threaten to deviate from their stated par values by more than an agreed-on percentage.

Such government intervention can be direct or indirect. Direct intervention requires a change in the foreign reserves where as indirect intervention is affected by manipulating the factors that determine exchange rates. Governments influence the exchange rate through increase or reduce the interest rates or other economic indicators such as income and inflation. Changes in these factors would not affect the foreign reserves. There are two types of direct intervention which are sterilized direct intervention and non-sterilized direct intervention.

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