Different Exchange Rate Systems

Countries of the world have been exchanging goods and services amongst themselves. This has been going on from time; immemorial. The world has come a long way from the days of barter trade. With the invention of money the figures and problems of barter trade have disappeared. The barter trade has given way ton exchanged of goods and services for currencies instead of goods and services.

Different countries have adopted different exchange rate system at different time. The following are some of the exchange rate system followed by various countries:

A. The Gold Standard

Many countries have adopted gold standard as their monetary system during the last two decades of the 19th century. This system was in vogue till the outbreak of World War 1. Under this system the parties of currencies were fixed in terms of gold. There were two main types of gold standard:

1. Gold specie standard: Gold was recognized as means of international settlement for receipts and payments amongst countries. Gold coins were an accepted mode of payment and medium; of exchange in domestic market also. A country was stated to be on gold standard if the following condition were satisfied:

  1. Monetary authority, generally the central bank of the country, guaranteed to buy and sell gold in unrestricted amounts at the fixed price.
  2. Melting gold including gold coins, and putting it to different uses was freely allowed.
  3. Import and export of gold was freely allowed.
  4. The total money supply in the country was determined by the quantum; of gold available for monetary purpose.

2. Gold Bullion Standard: Under this system, money in circulation was either partly of entirely paper and gold served as reserve asset for the money supply.  However, par money could be exchanged for gold at any time.  As the monetary authorities did not aspect all the paper currency to be converted into gold, there was no need or they to hold gold for covering money supply in full.

The exchange was determined by the gold content of the respective currency. E.g. if the gold content in Britain was 3 times US, then automatically pound sterling(GBP) was equivalent of 3 US dollars. This system is also known as ‘Mini Parity Theory’. After World War 1, all European gold standard countries left in 1936, thus the gold standard era was effectively over.

B. The Bretton Woods System

The bitter experience of war year, and danger of the recurrence looming large, forced the countries to create a free, stable and multilateral money system, which would help in restoration of international trade. As early as in 1943 USA and Great Britain accepted at the Bretton Woods Conference held in July 1944 and International Monetary Fund (IMF) was established in 1946.

In this system the member countries require to fix the parities of their currencies in terms US dollar or gold with fluctuations in their currency within 1% of limit. Due to massive deficit increased the supply of US dollar in international market and gold reserve held by USA were not sufficient to cover.

Through the Smithsonian Agreement, USA devalued dollar from 35 ounce to 38 per ounce, but could not last long.

The concept of one single currency of entire European was accepted way back in 1991 under Maastricht Treaty, and has come into reality effective January 4 1999 and the currency now has established independent currency since January 2001.

C. Purchasing Power Parity (PPP)

Professor Gustav Cassel, a Swedish economist, introduced this system. The theory, to put in simple terms states that currencies are valued for what they can buy. Thus if 135 JPY buy a fountain pen and the same fountain pen can be bought for USD 1, it can be inferred that since 1 USD or 135 JPY can buy the same fountain pen, there fore USD 1 = JPY 135.

For example if country A had a higher rate of inflation as compared to country A then goods produced in country A would become costlier as compared to goods produced in country B. This would induce imports in to country A and also the goods produced in country A being costlier, would lose in international competition to goods produced in country B. This decrease in exports of country A as compared to exports from country B would lead to demand for the currency of country B and excess supply of currency of country A. This in turn, causes currency of country A to depreciate in comparison of currency of country B which is having relatively more exports.

After the collapse of PPP system there came the Bretton woods System, and after the collapse of that Smithsonian Agreement. At present the floating rate system is used in all most countries.

About Abey Francis

Abey Francis is the founder of MBAKnol - A Blog about Management Theories and Practices - and he's always happy to share his passion for innovative management practices. You can found him on Google+ and Facebook. If you’d like to reach him, send him an email to: [email protected]
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