Balance-of-payments / Balance of Payments / Currency Mechanisms
- Fixed Exchange Rate:
- Definition: A fixed exchange rate is set and maintained by the central bank or monetary authority, and it remains constant against another currency or a basket of currencies.
- Characteristics:
- Central bank intervention to maintain the fixed rate.
- May not reflect market forces.
- India had a fixed exchange rate system until 1992.
- Floating Exchange Rate:
- Definition: A floating exchange rate is determined by market forces of supply and demand. The currency's value fluctuates based on market conditions without direct central bank intervention.
- Characteristics:
- Market-driven valuation.
- Central bank may indirectly influence rates through monetary policies.
- Reflects real-time market conditions.
- Dirty Float (Managed Float):
- Definition: A dirty float, or managed float, is a system where the exchange rate is primarily determined by market forces, but the central bank intervenes to manage fluctuations within a specified band.
- Characteristics:
- Central bank intervenes to influence rates.
- Target band declared by the central bank.
- Balances market-driven and managed elements.
- Pegged Exchange Rate:
- Definition: In a pegged exchange rate system, a currency is tied to the value of another major currency (e.g., the U.S. dollar) or a basket of currencies. The peg signifies a commitment to stability.
- Characteristics:
- Stability and credibility signaled by the peg.
- Movements may or may not follow the pegged currency.
- Requires sufficient forex reserves for stability.
- Crawling Peg:
- Definition: A crawling peg is a variation of the pegged exchange rate where the currency is allowed to gradually appreciate or depreciate at a predetermined rate.
- Characteristics:
- Acceptance of gradual movements.
- Announced annual rate for crawling.
- Balances stability with controlled flexibility.
Each of these currency mechanisms has its advantages and challenges, and the choice of a particular system depends on the economic goals and conditions of a country. Central banks often employ a mix of interventions and policies to maintain stability and competitiveness in the foreign exchange market.
