Exchange Rate Systems

Abstract

Currencies such as the euro, the yen, and the dollar trade freely in the world's forex markets, and their values fluctuate from minute to minute. The Hong Kong Monetary Authority, on the other hand, has kept the Hong Kong dollar between HKD7.75 = USD1 and HKD7.85 = USD1 since 1983. Between these extremes of freely floating exchange rates and fully fixed exchange rates are a wide variety of exchange rate systems. Understanding how these systems differ is critically important because the differences affect the currency risks international businesses face. This chapter examines the many different currency arrangements around the world. An important part of this discussion involves understanding the key role central banks and their international reserves play in the exchange rate systems. This chapter also describes how European countries created the European Monetary Union and came to adopt the euro as a common currency. This discussion is topical for three reasons. First, countries continue to adopt the euro as their currency; second, other groups of countries around the world may someday follow a similar scheme; and third, stresses within the euro zone have caused some European politicians to advocate abandonment of the euro and a return to domestic currencies. Understanding the constraints that adopting the euro has placed on different countries clarifies the desirability of such a system. Alternative Exchange Rate Arrangements and Currency Risk This section first surveys the spectrum of existing exchange rate arrangements. Then we summarize how different systems impose different currency risks on international businesses. Finally, we reflect on past and future trends in exchange rate arrangements. Exchange Rate Systems Around the World Exhibit 5.1 surveys the current arrangements in place across the world, using information from the International Monetary Fund. Although the IMF distinguishes more categories, the exchange rate systems can be split roughly into three broad categories: currencies with floating exchange rates, currencies that have fixed or pegged exchange rates, and currencies in which the exchange rate is kept in a target zone or allowed to follow a crawling peg.