Exchange Rate Systems

The exchange rate is the price of one currency in terms of another. Exchange rate systems determine how this price is set — whether by market forces, government intervention, or a combination of both. This lesson examines the three main exchange rate systems, evaluates their advantages and disadvantages, and introduces the Marshall-Lerner condition and the J-curve effect.

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What Is an Exchange Rate?

Key Definition: The exchange rate is the rate at which one currency can be exchanged for another. For example, if £1 = $1.25, then one pound sterling buys 1.25 US dollars.

A rise in the exchange rate (appreciation/revaluation) means the currency becomes more expensive — each unit buys more foreign currency. A fall in the exchange rate (depreciation/devaluation) means the currency becomes cheaper.

Term	Meaning	Context
Appreciation	Currency rises in value	Floating exchange rate
Depreciation	Currency falls in value	Floating exchange rate
Revaluation	Government raises the fixed rate	Fixed exchange rate
Devaluation	Government lowers the fixed rate	Fixed exchange rate

Exam Tip: Use "appreciation" and "depreciation" for floating rates, and "revaluation" and "devaluation" for fixed rates. Mixing these up is a common error that loses marks.

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1. Floating Exchange Rate

Under a freely floating exchange rate system, the value of the currency is determined entirely by the forces of supply and demand in the foreign exchange market, with no government intervention.

How It Works

• If demand for pounds increases (e.g., foreigners want to buy UK exports or invest in UK assets), the pound appreciates.
• If supply of pounds increases (e.g., UK residents buy more imports or invest abroad), the pound depreciates.

Advantages of Floating Exchange Rates

Advantage	Explanation
Automatic adjustment	The exchange rate adjusts to correct balance of payments disequilibria — a deficit causes depreciation, which makes exports cheaper and imports dearer
Monetary policy independence	The central bank is free to set interest rates according to domestic conditions (inflation, growth)
No need for large foreign currency reserves	The government does not need to buy or sell currencies to maintain a fixed rate
Reflects market fundamentals	The rate adjusts to changes in relative productivity, inflation, and interest rates

Disadvantages of Floating Exchange Rates

Disadvantage	Explanation
Volatility and uncertainty	Frequent fluctuations increase risk for international traders and investors
Speculation	Short-term capital flows can cause overshooting, moving the rate away from its fundamental value
Inflationary pressure	A depreciating currency raises import prices, which can feed into domestic inflation
May not correct imbalances	If demand for imports is price-inelastic, depreciation may worsen the trade balance (see Marshall-Lerner condition)

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2. Fixed Exchange Rate

Under a fixed exchange rate system, the government (or central bank) pegs the currency at a specific rate against another currency or a basket of currencies, and intervenes in the foreign exchange market to maintain that rate.

How It Works

• If the exchange rate falls below the peg, the central bank buys the domestic currency using its foreign currency reserves to increase demand for the domestic currency.
• If the exchange rate rises above the peg, the central bank sells the domestic currency (increasing supply) to bring the rate down.
• The government may also use interest rates and capital controls to maintain the peg.

Historical Examples

• The Bretton Woods system (1944–1971): currencies were pegged to the US dollar, which was convertible to gold at $35 per ounce.
• The Gold Standard (19th–early 20th century): currencies were fixed to a quantity of gold.
• The Exchange Rate Mechanism (ERM): European currencies were pegged to each other within narrow bands prior to the creation of the euro. The UK joined in 1990 but was forced out on Black Wednesday (16 September 1992) when speculators, led by George Soros, bet against sterling.

Advantages of Fixed Exchange Rates

Advantage	Explanation
Certainty and stability	Reduces exchange rate risk, encouraging international trade and investment
Anti-inflationary discipline	Countries must keep inflation low to maintain competitiveness at the fixed rate
Prevents competitive devaluation	Countries cannot artificially weaken their currencies to gain a trade advantage

Disadvantages of Fixed Exchange Rates