EXCHANGE RATE REGIMES

Exchange Rate Regimes

Exchange Rate Regimes

The exchange rate effects from exchange movements vary according to change in currency. The exchange rate risk is defined as the probability of loss from fluctuations in exchange rates of the currencies in which they are denominated assets, liabilities and off balance sheet entity. The exchange rate risk is a market risk that affects both the banking book and the trading book of a financial institution. Exchange rate risk is the uncertainty of the value of a currency that occurs when one currency is converted into another. This source of risk applies only if the investor acquires foreign assets denominated in a foreign currency. Benefits for international trade are obvious when the public wants a good thing that cannot be produced locally (Hossain, 359-373).

The concept of exchange rate regime refers to the methodologies adapted by the governments to manage their currencies relative to other currencies of the world. Some of the basic exchange rate regimes that are evident in the history and even in the present scenario are floating exchange rate, fixed or pegged exchange rate, and the pegged float exchange rate regimes.

Under fixed exchange rates with perfect capital mobility, monetary policy has no effect on the level of output or on interest rates, but fiscal policy is very powerful in changing the level of output. Similarly, other shocks to aggregate demand, such as autonomous changes in investment or consumption, also have large output effects. Under fixed exchange rates, devaluation (revaluation) of home currency raises (lowers) domestic output. The intuition behind many of these results is straightforward. Monetary policy loses power to affect output under fixed rates because it must be directed at keeping the exchange rate fixed (Obstfeld, 1995).

Over the past 150 years, the world has seen two extended intervals when countries followed fixed exchange rate policies. The first of these was known as the gold standard; it prevailed from about 1870 to the start of World War I in 1914 and then was revived for a few years in the late 1920s (Rose, 652-672). Individual countries set fixed prices of gold in terms of their currencies and then took actions to maintain those prices. Because all of the currencies in the system were fixed to gold, they were also fixed to each other. Virtually every major country and many of the then developing countries in the world participated in this system, so that fixed exchange rate prevailed worldwide. The second period of fixed exchange rates was known as the Bretton Woods system. The Bretton Woods era lasted from 1946 to early 1973. This system was administered in part by the International Monetary Fund (IMF). IMF member countries declared par values for the dollar in terms of their currencies and took steps to maintain those values. In the process, each country's currency was linked to all others in the system. In both cases, the worldwide system of fixed rates collapsed as individual countries came under pressure to change their exchange ...