An exchange rate is the price of one currency in terms of another currency. As in the case of any other goods, the price of a currency is affected by supply and demand. As demand for a currency increases (or supply decreases) its price will rise. This is referred as an appreciation. Conversely, as demand for a currency decreases, or supply increases, its value will depreciate. The prospect of large and rapid swings in exchange rates introduces uncertainty into the business environment. A well-functioning international monetary system ensures stability in the exchange rates. The central element of the international monetary system involves the arrangements by which exchange rates are set. The purpose of an exchange-rate system is to facilitate and promote international trade and finance. There have been three major exchange rate regimes from a historical perspective – Fixed Exchange Rates, Floating or Flexible Exchange Rates, and Managed Exchange rates.
The current exchange rate system is a hybrid of many different arrangements. The International Monetary Fund classifies these exchange rate regimes into eight specific categories. The eight categories span the spectrum of exchange rate regimes from rigidly fixed to independently floating:
- Exchange Arrangements with No Separate Legal Tender: The currency of another country circulates as the sole legal tender or the member belongs to a monetary or currency union in which the same legal tender is shared by the members of the union.
- 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.
- Other Conventional Fixed Peg Arrangements: The country pegs its currency at a fixed rate to a major currency or a basket of currencies , where the exchange rate fluctuates within a narrow margin or at most ±1% around a central rate.
- Pegged Exchange Rates within Horizontal Bands: The value of the currency is maintained within margins of fluctuation around a formal fixed peg that are wider than ±1% around a central rate.
- Crawling Pegs: The currency is adjusted periodically in small amounts at a fixed, pre-announced rate or in response to changes in selective quantitative indicators.
- Exchange Rates within Crawling Pegs: The currency is maintained within certain fluctuation margins around a central rate that is adjusted periodically at a fixed pre-announced rate or in response to change in selective quantitative indicators.
- Managed Floating with No Pre-Announced 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-committing to a pre-announced path for the exchange rate.
- Independent Floating: The exchange rate is market determined, with central bank intervening only to moderate the speed of change and to prevent excessive fluctuations, but not attempting to maintain it at or drive it to any particular level.
The United States, the EU, Japan, the United Kingdom, Switzerland, and Canada are among the major countries that follow an independent floating policy. At the other end of the exchange rate regime spectrum (from floating to fixed) is the currency board, which is a monetary regime based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation. Argentina was an example before the system failed in 2002. Currently, Hong Kong is a well known example of such an arrangement.