System of Exchange Rate

In the wake of the collapse of the Bretton Woods exchange rate system, the IMF appointed the Committee of Twenty that suggested for various options for exchange rate arrangement. Those suggestions were approved at Jamaica during February 1976 and were formally incorporated into the text of the Second Amendment to the Articles of Agreement that came into force from April 1978.

The options were broadly:

• Floating Rate System: It is the market forces that determine the exchange rate between the two different 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 macro-economic variables. As a result, there does not appear any gap between the real exchange rate and the nominal exchange rate.
• Pegging of Currency:  Normally, a developing country pegs its currency to a strong currency or to a currency with which it has a very large part of its trade. Pegging involves fixed exchange rate with the result that the trade payments are stable. 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 currency is advised. But if the basket is very large, multi-currency intervention may prove costly.
• Crawling Peg:  Again, a few countries have a system of crawling peg. Under this system, they allow the peg to change gradually over time to catch up with the changes in the market-determined rates. It is a hybrid of fixed-rate and flexible-rate systems. So this system avoids too much of rigidity and too much of instability.
• Target-zone Arrangement:  In a target-zone arrangement, the intra-zone exchange rates are fixed. There are cases where the member countries of a currency union do not have their own currency; rather they have a common currency.