Since March 1973, exchange rates have become much more volatile and less predictable than they were during the ―fixed‖ exchange rate period, when changes occurred infrequently. In general the dollar has been volatile and has weakened somewhat over the long run. On the other hand, the Japanese yen and German mark have strengthened. The emerging market currencies have been exceptionally volatile and have generally weakened.
In the wake of the collapse of the Bretton Woods exchange rate system, the IMF appointed the Committee of Twenty which suggested various options for the exchange rate arrangement. These suggestions were approved at Jamaica during February 1976 and were formally incorporated into the text of the Second Amendment to the Articles of Agreement, which came into force from April 1978. The options were broadly:
- Floating-independent and managed
- Pegging of currency
- Crawling peg
- Target zone arrangement
1. Floating Rate System: In a floating-rate system, it is the market forces that determine the exchange rate between two currencies. The advocates of the floating rate system put forth two major arguments. One is that the exchange rate varies automatically according to the changes in the macroeconomic variables. As a result, there is no gap between the real exchange rate and the nominal exchange rate. The country does not need any adjustment, which is often required in a fixed rate regime and so it does not have to bear the cost of adjustment. The other argument is that this system possesses insulation properties, meaning that the currency remains isolated from the shocks emanating from other counties. It also means that the government can adopt an independent economic policy without impinging upon the external sector performance.
In case of Managed Floating with no preannounced path for the exchange rate, the monetary authority influences the movements of the exchange rate through active intervention in the foreign exchange market without specifying, or pre-commiting to, a pre-announced path for the exchange rate. In case of Independent Floating, the exchange rate is market-determined, with any foreign exchange intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than at establishing a level for it.
2. Pegging of Currency: Normally, a developing country pegs its currency to a strong currency or to a currency with which it conducts a very large part of its trade. Pegging involves fixed exchange rate with the result that trade payments are stable. But in case of trading with other countries, stability cannot be guaranteed. This is why pegging to a single currency is not advised if the country‘s trade is diversified.
In such cases, pegging to a basket of currencies is advised. But if the basket is very large, multi-currency intervention may prove costly. Pegging to SDR is not different insofar as the value of the SDR itself is pegged to a basket of five currencies.
3. Crawling Peg: Again, a few countries have a system of a crawling peg. Under this system, they allow the peg to change gradually over time to catch up with changes in the market-determined rates. It is a hybrid of fixed-rate and flexible rate systems. So this system avoids too much of instability and too much of rigidity. In some of the countries opting for the crawling peg, crawling bands are maintained within which the value of currency is maintained. The currency is adjusted periodically in small amounts at a fixed, preannounced rate or in response to changes in selective quantitative indicators.
4. Target Zone Arrangement: In a target zone arrangement, the intra-zone exchange rates are fixed. An apposite example of such an arrangement was found in European Monetary Union (EMU) before coming in of Euro. However, there are cases where the member countries of a currency union do not have their own currency, rather they have a common currency. Under this group, come the member countries of the Eastern Caribbean Currency Union, the Western African Economic and Monetary Union, and the Central African Economic and Monetary Community. The member countries of the European Monetary Union too came under this group with the Euro substituting their currency in 2002.
5. Others: Apart from the models discussed above there do different countries follow some more practices. They are:
- Currency Board Arrangements: A monetary regime based on an implicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation.
- Dollarization: Several countries that have suffered for many years from currency devaluation, primarily as a result of inflation, have taken steps towards dollarization, the use of the U.S. dollar as the official currency of the country.