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2020/08/17

The exchange rate system: fixed, flexible, managed float

The exchange rate system is largely divided into three types: fixed exchange rate system, variable exchange rate system, and limited exchange rate system, depending on the degree and type of flexibility of exchange rate changes.

Fixed exchange rate system (or sometimes called pegged)
The fixed exchange rate system contributes to stable economic growth by reducing the cost of exchange rate fluctuations and economic uncertainty. When the term first came out, it was fixed with commodity such as gold. It was intervened by governments and central banks in the currency market by intentional selling and purchasing.

It is mostly selected by emerging countries because of the high cost of exchange rate fluctuations due to the lack of financial market development, lack of ability to manage exchange risk, and lack of government confidence.
Meanwhile, some argue that the fixed exchange rate system is inappropriate under the international financial environment, where capital mobility has increased significantly due to the progress of financial liberalization and globalization.

Major countries: Saudi Arabia, Hongkong, UAE, Jordan, Cuba, Qatar etc

However, the fixed exchange rate system is highly likely to be exposed to foreign exchange attacks by international speculative funds like George Soros did by betting British Pound collapse. When the fundamental of the country is deteriorated then it affects directly on the currency that leads to external currency imbalances
* The collapse of the European Monetary System (EMS) in 1993, the instability of the Hong Kong foreign exchange market in 1997, and the Asian financial crisis in 1997.

Flexible exchange rate system (or sometimes called free-floating)
It allows free exchange rate fluctuation fully affected by supply and demand of the market itself. Governments and central banks do not participate in the Forex market at all. The advantages of the floating exchange rate system as follows:

Inducing equalization
Deficit of balance of payments → demand over foreign exchange → depreciation of local currency → increase competitiveness → boost exports, decrease of imports → recovery of international balance.

Prevention to foreign exchange speculation
Free exchange rate fluctuations block foreign exchange speculation due to uncertainty about future currency movements.

Maximizing policy efforts
Because there is no limit to maintaining a certain level of exchange rate (price can be variable anytime), independent economic policies can be implemented and policy efforts can be concentrated on the balance of the domestic economy to maximize policy effectiveness.

Proper management of foreign exchange reserves 
Preventing excessive accumulation of foreign exchange reserves as central banks do not need to intervene in the foreign exchange market to defend specific exchange rate levels.

However, the concept of full free-floating exchange rate system is just theoretical. Indeed, every government or central bank intervenes in the currency market to affect the exchange rate for their advantage of trade. Some countries, such as Japan, Korea, and the United States, intervene in very little.

Managed float regime (or sometimes considered as dirty float)
Governments and central banks often seek to increase or decrease their exchange rates by buying or selling their own currencies. Exchange rates are still free to float, but governments try to influence their values. It is a fixed and variable intermediate-level exchange rate system, which limits the exchange rate fluctuation width to within a certain range (1-2.25% etc.) for a particular currency. Countries such as China choose managed float system.

Source
https://saylordotorg.github.io/text_principles-of-economics-v2.0/s33-03-exchange-rate-systems.html

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