Exchange Rate Mechanism -- Types

What are types/categories of Exchange Rate Mechanism?

Jamoore and Madariwala will help us in understanding Exchange Rate Mechanism.

Jamoore: China is devaluing its currency, and we are worried. What is the story behind it Ustad.

Madariwala: Then listen. Today I am free. It is going to be pastime and fun for me and headache for you. Exchange rate mechanism is a sarkari chaal (Government strategy/policy). Exchange Rate Mechanism can be broadly classified into following catagories:

1. Fixed Exchange Rate Mechanism

2. Freely Floating Exchange Rate Mechanism

3. Managed Float Exchange Rate Mechanism

4. Pegged Exchange Rate Mechanism

Let me first explain 'Pegged Exchange Rate Mechanism'.

Jamoore, are you seeing that beautiful garden of fruits? 

Jamoore:Yes Ustad (Master)

Madariwala: When the garden is laden with fruits of all kind, birds of all hues are there. As the fruits vanish, and greenery fades, birds leave this garden for some other greener pasture. Likewise foreign investors leave the country of current  investment for some better investment opportunities. This may be the consequence of ‘Pegged Exchange Rate Mechanism’.

Now, let us see what is ‘Pegged Exchange Rate Mechanism’. Peg is called ‘khoonta’ in local parlance. This is like tying camel to ‘khoonta’. If a country pegs its currency to some other foreign currency, generally to stable currency like dollar, this arrangement is known as ‘Pegged Exchange Rate Mechanism’. As long as home country’s economy is sound, and political stability is there, this mechanism works. Otherwise we have example of Mexican Peso crisis.   

Jamoore, are you sleeping? Still we have three mechanisms left to explain.

Jamoore: The story is good Ustad. You can carry on.

Madariwala: OK, then I am going to conclude very quickly.

Fixed Exchange Rate Mechanism: Jamoore, bring four samosas from Kachouriwala. Ask him to give Rs. 2 concession per samosa.

Jamoore: What are you talking ustad. He is not going to give discount of a single penny. He is very particular about the price, and his price is fixed. People are confident while purchasing from this shop.

Madariwala: Likewise, in ‘Fixed Exchange Rate Mechanism’, Exchange Rate is held constant. So exporters and importers are not concerned about exchange rate movement.

Freely Floating Exchange Rate Mechanism:  Exchange rate values are determined by market forces without government’s intervention.

Managed Float Exchange Rate Mechanism: Also called ‘dirty float’.  It lies between Freely Floating and Fixed. Exchange rate is allowed to float freely on daily basis, and government intervenes whenever exchange rate crosses too far.

Jamoore, it is just like allowing horse to graze in the field, and as it strays to different field, the horse is again put back in the field by his master.