An exchange rate system or regime is a single or intergovernmental agreement involving the formation of the exchange rate. Thus the exchange relationship between two currencies is based on uniform principles. The exchange rate regime is also determined by the supply and demand patterns in the foreign exchange market.
In systems of fixed exchange rates, however it is fixed by the governments of the participating countries to a certain value. There are also many intermediate and special configurations. The choice of an exchange rate system of a country is influenced by political objectives and existing international economic links.
Floating rates are currently the most familiar exchange rate regime, for instance, the British pound, dollar, euro, and yen all float. Even though, central banks regularly step in to prevent unreasonable appreciation or depreciation, such regimes are usually known as dirty float or managed float.
Flexible exchange rates meet the principle of a market price on the foreign exchange market. The price formation is carried out by the coincidence of supply and demand, that is, in principle, without government intervention.
The market mechanism in the foreign exchange market, or the so-called exchange rate mechanism, ensures that the supply and demand levels remain at the equilibrium exchange rate (foreign exchange market equilibrium). The exchange rate positions between the dollar and the Euro is, for example, according to this principle.
For the emergence of an equilibrium in the foreign exchange market, the condition of interest rate parity must be met. This hypothesis states that the effective yield of domestic and foreign investments must be the same. It implies that interest rate differentials between domestic and foreign investments are based solely on expected exchange rate changes. That is, the equilibrium price is equal to the expected short-term returns.
In systems with fixed exchange rates agreed by the countries involved in a fixed central rate (the so-called parity), they typically endeavor to keep it constant through interventions. The exchange rate can then be bound by the central bank to another currency or a basket of currencies.
The exchange rates of countries with a system of fixed exchange rates are not always steady. Fixed exchange rates are usually deined by bandwidth systems, in which the exchange rates hover within certain ranges (eg + / – 1%) of the central parities.
Pegged floats include crawling bands whose rate is permitted to waver in a band close to a primal value, that is conformed regularly. This is carried out at a pre-announced rate or in a moderated manner keeping abreast with economic indicators. With crawling pegs the rate is fixed, while pegged horizontal bands permit the currency to waver in a fixed band close to a primal rate.
The main advantage of a system of flexible exchange rates is that the independent monetary policy is maintained in the country. There is thus a greater ability to respond to shocks.
The choice of an exchange rate system is also influenced by national interests and international commercial links. For example, a country which has close trade relations with neighboring countries, and is highly dependent on exports and in which the export sector is very much key, a system of fixed exchange rates is favored.