UNIT 7 EXCHANGE RATE REGIMES 

Exchange Rate
Regimes

Structure
7.0 Objectives
7.1 Introduction
7.2 Concepts
7.3 Importance of foreign exchange for the economy
7.4 Evolution of international exchange rate regimes
7.4.1 The Pre-World War I (WWI) financial order (1870–1914)
7.4.2 Between the World Wars (1919–1939)
7.4.3 The Bretton Woods Era (1945–1971)
7.4.4 The post-Bretton Woods system (1971–present)
7. 5 Forms of Exchange rate regime
7.5.1 Fixed exchange rate
7.5.2 Floating exchange rate
7.5.3 Managed floating
7.5.4 Recurrence of instability suggests a new regime
7.6 India’s exchange rate regime
7.7 Let us sum up
7.8 Key Words
7.9 Some Useful References
7.10 Answer/Hints to Check your Progress Exercises

7.0 OBJECTIVES
After studying this Unit, you should be able to:
 explain the concepts of:
foreign exchange,
exchange rate, and exchange rate regimes;
 distinguish between different forms of exchange rate regimes;
 discuss the advantages and disadvantages of: fixed, floating, and managed
float;
 trace briefly the historical development of international exchange rate
regimes;
 examine operational aspects of the current exchange rate regimes; and
 provide an overview of India’s exchange rate regime.


Contributed by Prof. S.K. Singh, Retd. Prof. IGNOU
137
Exchange Rate and
Balance of Payments 7.1 INTRODUCTION
The exchange rate regime greatly impacts world trade and financial flows. The
volume of such transactions and the speed at which they are growing highlight
the crucial role of the exchange rate in today’s world, thereby making the
exchange rate regime a central piece of any national economic policy framework.
The choice of an appropriate exchange rate regime—floating, managed or fixed
arrangements—for individual countries is important. After all, an exchange rate
regime that looks soft to one observer may look hard to another—which reflects,
among other things, a lack of information among different players about foreign
exchange markets and purchases or sales of foreign exchange by central banks.
Which exchange rate regime and associated policies are appropriate for a country
depending on its circumstances? No country can afford to be entirely indifferent
to the behaviour of its exchange rate as it is closely related to the country's
monetary policy, with both depending on common factors of influence and
impact. In this unit, we discuss various aspects of the foreign exchange regime.

7.2 CONCEPTS
It is important to understand terms such as ‘foreign exchange’, ‘exchange rate’,
and ‘exchange rate regime’ as they are central to understanding the economy
around.
Foreign Exchange: ‘Foreign exchange’ refers to money denominated in a
currency other than the domestic currency. Foreign exchange can be cash, funds
available on credit cards and debit cards, and bank deposits.
Exchange rate: The rate at which a currency of one country exchanges for
another country's currency is called the ‘exchange rate'. The exchange rate can
either be expressed in terms of the number of units of domestic currency per unit
of foreign currency (direct quotation) as in the case of most currencies such as
the Indian rupee. For example, if the exchange rate between the rupee and the US
dollar (USD) is quoted as Rs.65, this means that Rs.65 is required to purchase
US$1.00. Or the number of units of foreign currency per unit of domestic
currency (indirect quotation) as in the case of some major trading currencies such
as the pound sterling and the Australian dollar. When the value of the domestic
currency increases in terms of another currency, it is referred to as a nominal
appreciation of the domestic currency. In contrast, a decrease in the value of the
domestic currency in terms of a foreign currency is known as nominal
depreciation.
Exchange rate regime: An exchange rate regime is the process by which a
country manages its currency with respect to foreign currencies. Exchange rate
regimes can broadly be categorized into two extremes: fixed and floating.
Between these, there are several combinations of the two. The exchange rate
system refers to the arrangement for the movement of the exchange rate.
138 Countries in the world operate under different exchange rate regimes.
 Exchange Rate
7.3 IMPORTANCE OF FOREIGN EXCHANGE FOR Regimes
THE ECONOMY
The exchange rate is a key financial variable that affects decisions made by
foreign exchange investors, exporters, importers, bankers, businesses, financial
institutions, policymakers and tourists in the developed and developing world.
Exchange rate fluctuations affect the value of international investment portfolios,
the competitiveness of exports and imports, the value of international reserves,
the currency value of debt payments, and the cost to tourists in terms of the value
of their currency. Thus, exchange rate movements have important implications
for the economy's business cycle, trade and capital flows and are therefore crucial
for understanding financial developments and changes in economic policy.
The exchange rate performs the same function as other prices in a mixed
economy market. It provides information and incentives to guide decisions about
what to produce and what to consume. Considered as a price, however, the
exchange rate has special qualities. It is probably the single most important price
in the economy. It affects numerous other prices and touches the interests of
many people. This makes it the centre of much controversy with major exchange
rate changes inviting popular attention. The exchange rate further links the
general level of prices in the national economy with prices in other countries.

Check Your Progress 1

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Define Exchange Rate.
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2) Why do exchange rates exist?
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3) Why is it important to study the exchange rate regime?
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Exchange Rate and
Balance of Payments 7.4 EVOLUTION OF INTERNATIONAL
EXCHANGE RATE REGIMES
The first modern international exchange rate regime was the gold standard. The
adoption of the Gold Standard was a gradual process. There was no international
legal foundation—no treaties, agreements or conferences. The various versions of
the gold standard used were:
a) gold specie standard,
b) gold bullion standard, and
c) gold exchange standard.
Fiat currencies are the norm in today's national economies and the current
exchange rate regime. Stages in the development of an exchange rate regime
may be grouped under the following four heads:

7.4.1 The pre-World War I (WWI) financial order (1870–1914)

The gold standard widely adopted in this era rested on converting paper notes
into pre-set quantities of gold. From the 1870s to the outbreak of World War I in
1914, the world benefited from a well-integrated financial order, sometimes
known as the first age of globalisation. Transactions were facilitated by
widespread participation in the gold standard by independent nations and their
colonies. This era saw mostly steady growth and a relatively low level of
financial crises. The pre–World War I financial order was not created at a single
high-level conference; rather it evolved organically in a series of discrete steps.

7.4.2 Between the World Wars (1919–1939)

The years between the world wars have been described as a period of
de-globalisation, as both international trade and capital flows shrank compared to
the period before World War I. During World War I, countries had abandoned
the gold standard and, except for the United States, returned to it only briefly. By
the early '30s, the prevailing order was essentially a fragmented system of
floating exchange rates. In this era, the experience of Great Britain and others
was that the gold standard ran counter to the need to retain domestic policy
autonomy.
By the end of World War I, Great Britain was heavily indebted to the United
States, allowing the USA to largely displace her as the world's number one
financial power. As the Great Depression intensified in 1930, financial
institutions were hit hard along with trade. Frequent changes in exchange rates
introduced considerable uncertainty and made things difficult for the smooth
conduct of international trade. This was amply proved by the experience of
countries during the inter-war period, i.e., 1919-1939, which was marked by:
i) competitive devaluation of currencies;
ii) chaos in foreign exchange markets;
140 iii) the decline in world trade;
iv) imposition of trade restrictions; and Exchange Rate
Regimes
v) widespread unemployment.
The lessons of the inter-war experience with exchange rates are:
a) exchange rates should be reasonably stable for the smooth conduct of
international trade;
b) this can be achieved if countries, particularly advanced countries, cooperate;
and
c) International cooperation is the basis of a sound international monetary
system or international exchange arrangement.

7.4.3 The Bretton Woods Era (1945–1971)

The principal architects of the new system, John Maynard Keynes and Harry
Dexter White created a plan which was endorsed by the 42 countries attending
the 1944 Bretton Woods conference, formally known as the United Nations
Monetary and Financial Conference. The plan involved nations agreeing to a
fixed but adjustable exchange rate system where the currencies were pegged
against the dollar, with the dollar itself convertible into gold. So in effect, this
was a gold-dollar exchange standard. There were several improvements to the old
gold standard. Two international institutions, the International Monetary Fund
(IMF) and the World Bank were created. The new exchange rate system allowed
countries facing economic hardship to devalue their currencies by up to 10%
against the dollar (more if approved by the IMF) – thus they would not be forced
to undergo deflation to stay in the gold standard. A system of capital controls was
introduced to protect countries from the damaging effects of capital flight and to
allow countries to pursue independent macroeconomic policies while still
welcoming flows intended for productive investment. However, pressing
circumstances caused President Nixon to end all convertibility into gold on 15
August 1971. This event marked the effective end of the Bretton Woods system
resulting in a system of floating exchange rates.

7.4.4 The post-Bretton Woods system (1971–present)

President Nixon is credited with ending the Bretton Woods Accord, and fixed
rates of exchange, eventually creating a free-floating currency system. The
current era has seen huge and turbulent flows of capital between nations. The
transition away from Bretton Woods was marked by a switch from a state led to a
market-led system. The Bretton Woods system is considered by economic
historians to have broken down in the 1970s. Crucial events being:
i) Nixon suspended the dollar's convertibility into gold in 1971,
ii) the United States abandonment of capital controls in 1974, and
iii) the UK's ending of capital controls in 1979 which was swiftly copied by most
other major economies.
141
Exchange Rate and
Balance of Payments The contemporary exchange rate regime popularly known as ‘non-system’ is
profoundly different from those envisaged at the 1944 meeting at Bretton Woods.
The IMF officially endorsed the non-system at a meeting in Jamaica in January
1976. In the current system, exchange rates among the major currencies
(principally the U.S. dollar, the euro, and the Japanese yen) fluctuate in response
to market forces, with short-run volatility and occasional large medium-run
swings. The IMF's approach continues to advise member countries on the
implications of adopting different exchange rate regimes, consider the regime's
choice to be a matter for each country to decide, and provide policy advice that is
consistent with the maintenance of the chosen regime.

Check Your Progress 2

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Briefly outline the historical development of the exchange rate regime before
World War II.

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2) Examine the exchange rate regime from the Bretton Woods era to the present.

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7.5 FORMS OF EXCHANGE RATE REGIME

7.5.1 Fixed exchange rate
Under a fixed exchange rate system, a country's monetary authority agrees to
manage its affairs to maintain a fixed ratio between the value of its own currency
and that of other countries. A country's currency, therefore, has a definite
objective value in terms of the other currencies into which it can be freely
converted. The domestic currency is tied to another foreign currency, mostly
more widespread currencies such as the U.S. dollar, the euro, the Pound Sterling
or a basket of currencies. The government (or the central bank acting on the
government's behalf) intervenes in the foreign exchange market to ensure that the
exchange rate stays close to a predetermined target.
Under this system, exchange rate stability is achieved but if the exchange rate is
fixed at the wrong rate, it may be at the expense of domestic economic stability.
In a fixed exchange rate system, a rise in the exchange rate of the domestic
142 currency vis-à-vis another foreign currency is called a devaluation. This means
that more of the domestic currency is needed to buy 1 unit of a given foreign Exchange Rate
Regimes
currency. On the other hand, when the exchange rate falls, it is termed as a
revaluation. These terms imply a deliberate decision on the government's part to
change the exchange rate level. For example, a government's policy decision to
devalue the domestic currency vis-à-vis the US dollar from Rs.65 to Rs.70.
It is important to realize that fixity cannot be achieved by simple government
decree. There are powerful economic forces at work in the foreign exchange
markets; restricting the movement of currencies requires equally decisive
countervailing action by the authorities. This can take two broad forms: direct
intervention in the foreign exchange using so-called open market operations, or
the less direct option of interest rate manipulation. Fixing an exchange rate very
rarely involves establishing a single point away from which a currency is not
permitted to move. The usual approach is to define a target zone for the currency.
The authorities then respond with appropriate measures when market forces
threaten to move the currency above or below the zone. Theoretically, then, it is
possible to hold a currency at any given rate, so long as the associated excess
demand or supply of the currency at that rate can be met. The other policy
measure that can be used as an alternative or supplement to open market
operations involves the noted use of interest rates.
Advantages
i) Provides greater certainty for exporters and importers as there are no or
limited exchange rate risks. Hence it promotes long-term capital flows.
ii) There is no fear of the adverse effect of speculation on the exchange rate.
iii) Businesses have the knowledge that the price is fixed and therefore not going
to change; it is relatively easier for them to plan.
iv) Encourages international trade by making prices of goods involved in trade
more predictable. It leads to low inflation.
v) Imposes the discipline necessary for exchange rate stability; monetary policy
must be coordinated. Keynes was a chief architect of Bretton Woods and a
strong proponent of fixed rates. Many Keynesians agree that government
intervention is necessary to promote exchange rate stability. However, the
question remains how to attain a stable exchange rate system?
Disadvantages
i) Have a high administration cost. Needs a complicated exchange control
mechanism which may lead to the misallocation of resources.
ii) A significant gap between the official rate and that determined by the market
can promote black markets. In a black market, most foreign exchange
transactions are carried out outside the banking system.
iii) This may force the government to draw down on reserves to meet its
obligations and cause a scarcity of foreign exchange. 143
Exchange Rate and
Balance of Payments iv) Restricts the ability of countries to conduct policy autonomously.
v) Inimical to the very desirable objective of free trade.
vi) May achieve exchange rate stability but at the expense of domestic economic
stability.

7.5.2 Floating exchange rate

A flexible system follows free market principles. Exchange rate determination is
left entirely to the currency supply and demand processes, and governments do
not attempt to manipulate the market to have particular exchange rate outcomes.
Popular regimes run the gamut from currency boards and traditional pegs to
crawling pegs, target zones and floats with varying degrees of intervention. It is
closely related to monetary policy and the two are generally dependent on many
of the same factors. The broad system of flexible exchange rates prevailing in the
world economy since 1973.
Since market forces determine the exchange rate, the upward and downward
movements in the value of the rupee are appreciation and depreciation.
Depreciation of the rupee refers to the decrease in the external value of the
domestic currency that occurred due to the operation of market forces.
Appreciation of the rupee refers to the increase in the external value of the
domestic currency that occurred due to the operation of market forces. The
exchange rate is determined in the open market through the pressure of buying
and selling foreign currencies.
Advantages
i) A flexible exchange rate system confers several advantages upon economies
that adopt it:
ii) Continuous changes are easier to adjust to.
iii) Less likely to permit a payments crisis to develop. Appropriate corrective
exchange rate movements will swiftly dissipate any early or ‘incipient’ deficit
or surplus that might arise. This system automatically provides for a balance
of payments stability without the need for any action whatsoever by policy-
makers.
iv) Less politicized and authorities do not intervene in the market for foreign
exchange and there is minimal need for international reserves.
v) Less likely to have adverse domestic repercussions. Provides fewer incentives
for destabilizing speculation. Financial instruments are available to hedge the
risks posed by a fluctuating exchange rate.
vi) Allows nations to pursue their own independent economic goals in respect of
the other objectives of macro policy. Gives the government/monetary
144 authorities flexibility in determining interest rates. This is because interest
 Exchange Rate
rates do not have to be set to keep the value of the exchange rate within pre- Regimes
determined bands.
vii) Offers the most appropriate framework for the international allocation of
resources through the trade process.
Disadvantages
i) Market forces may fail to determine the appropriate exchange rate; hence, the
floating exchange rate regime may not provide the desired results and may
lead to the misallocation of resources.
ii) It is impossible to have an exchange rate system without official intervention.
The government may not intervene, however domestic monetary policy and
fiscal policy would influence the exchange rate.
iii) A wildly fluctuating exchange rate is at the mercy of national and
international currency speculators. A volatile exchange rate introduces
considerable uncertainty in export and import prices and consequently to
economic development. At the same time, the abolition of exchange controls
causes capital flight.

7.5.3 Managed floating

Many countries are practising a system of the managed floating exchange rate at
present. The central banks have been trying to control fluctuations of exchange
rates around some ‘narrow band’, however, the demand and supply forces
determine the exchange rate. The decision to vary exchange rates can occur in
the context of a variety of international monetary payment schemes. Countries
may operate at a fixed rate but allow occasional variations for fundamental
disequilibria. This is the adjustable peg system whereby rates can be pegged at
new levels. Countries may allow rates to vary freely within agreed bands.
Countries may allow unrestricted variation of rates. This allows a country to
dispense with holding foreign reserves which represent a sacrifice of
consumption.
In this hybrid exchange rate system, the exchange rate is determined in the
foreign exchange market through the operation of market forces. Market forces
mean the selling and buying activities by various individuals and institutions. The
management of a floating rate is sometimes referred to in the literature as a 'dirty
float’. It is unlikely that the authorities in any country could remain completely
indifferent to the behaviour of the exchange rate, and yet this is what the
advocate of completely flexible rates recommends. Managed or dirty floating is
the more usual alternative to participation in a fixed exchange rate system. In
practice, a managed fiat permits the authorities to intervene in the foreign
exchange markets, using direct open market operations, interest rates, or some
combination of both. 145
Exchange Rate and
Balance of Payments In this context, the following table is very instructive:
Table 7.1: Forms of exchange rate regime

Fixed Adjustable Crawling Managed Winder Freely

(pegged) Peg Peg Float Band
Floating
Exchange System
Exchange
Rate
Rate

A B
In the Table, as one moves from point A on the left to point B on the right, both
the frequency of intervention by domestic monetary authorities and the required
level of international reserves tend to be lower. Under a pure fixed-exchange-rate
regime (point A), authorities intervene so that the value of the domestic currency
vis-a-vis another country's currency says the US Dollar, is maintained at a
constant rate. Under a freely floating exchange-rate regime, authorities do not
intervene in the market for foreign exchange and there is minimal need for
international reserves.
However, it remains true that there is no single exchange rate regime that is best
for all countries in all circumstances. Countries continue to have the scope to
choose the type of exchange rate regime that best suits their needs, always with
the proviso that the chosen regime must be credibly supported by policies
consistent with the choice. In light of important changes which include the
general increase in capital mobility and the abrupt reversals of capital flows to
developing and transition economies.

7.5.4 Recurrence of instability suggests a new regime

It is important to note that currently there have been shifting trends in the
exchange rate regime. After the breakdown of Bretton Woods, countries have
adopted a wide variety of regimes, ranging from 'dollarisation' and currency
boards to simple pegs and basket pegs, crawling pegs and target zones to clean
floats and dirty floats. There is such an abundance of possible linkages between
the exchange rate regime and macroeconomic performance—some offsetting,
others reinforcing—that, at a theoretical level, it is difficult to establish any
unambiguous relationships at all. While increased capital mobility has been
leading an increasing number of countries to either end of the spectrum between
firmly fixed rates (or monetary unification) and free-floating, intermediate
regimes are likely to remain viable and appropriate in many cases.

146
The recurrence of concerns and phases of instability suggests a need to look for Exchange Rate
Regimes
durable remedies. Leaders continue to campaign for Bretton Woods II. It has
been a feature of the non-system that exchange rates have at times, moved to
positions that appear to be at variance with conditions prevailing in, and the
longer-term interests of, domestic economies. Currently, the world economy is
generally organised along flexible lines, but many countries choose to manage
their currencies either alongside or in partnership with other currencies and
countries.
There is a demand for reform in the International Monetary System. Zhou
Xiaochuan, the former governor of the People's Bank of China proposed a
gradual move towards increased use of IMF special drawing rights (SDRs) as a
centrally managed global reserve currency. His proposal attracted much
international attention. In December 2011, the Bank of England published a
paper arguing for reform, saying that the current regime has performed poorly
compared to the Bretton Woods system.
The steps required to move to an SDR-based system would be groundbreaking. A
somewhat less ambitious alternative would be to make the SDR one of the
alternative reserve currencies in a multicurrency system. Despite its relative
stability, the current ‘non-system’ has the inherent weaknesses of a setup with a
dominant country-issued reserve currency, wherein the reserve issuer runs fiscal
and external deficits to meet growing world demand for reserve assets and where
there is no ready mechanism forcing surplus or reserve-issuing countries to
adjust.
The current system has flaws, including occasional bouts of serious instability,
but it has proved its strength and resilience when the conceivable alternatives
have not. Charting the road ahead, the main task should be to help policymakers
think beyond the status quo in fundamental ways. In this spirit, serious
consideration should be given to alternatives to self-insurance, and to the
potential—practical and political—for other currencies to acquire a greater role
in the global reserve system. Such work could help the system evolve to shape
developments rather than the other way around, as has historically tended to be
the norm.
Neither the theory nor country experiences are very conclusive nor do exchange
rate regimes have their benefits and costs. The suitability of a particular regime,
however, depends on the policy target of a country.

Check Your Progress 3

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What are the main types of exchange rate systems? Does the choice of
exchange rate regime matter?
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Exchange Rate and
Balance of Payments 2) Explain the differences between fixed and flexible exchange rate systems and
the advantages and disadvantages of each.

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3) What is Managed Floating Exchange Rate System?

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4) What are the main factors which determine the effectiveness of a floating
exchange rate policy? Currently, which type of system determines the values
of the major currencies, such as the Dollar, Yen, and Euro?

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5) What is a currency appreciation or depreciation? Point out the advantages and
disadvantages of each.

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6) Explain how the choice of an exchange rate regime alters the conduct of
monetary policy?

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7) Do you think the operation of non-system and recurrence of crisis needs a
new regime for currency?

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7.6 INDIA’S EXCHANGE RATE REGIME

The main objectives of India’s exchange rate policy are to ensure that the
economic fundamentals are truly reflected in the external value of the rupee. In
the post-independence period, India's exchange rate policy has shifted from a par
value system to a basket-peg and to a managed float exchange rate system. The
policy has evolved in line with the gradual opening up of the economy as part of
the broader strategy of macroeconomic reforms and liberalization since the early
1990s.
148
India's rupee has matured to a regime of the floating exchange rate from the Exchange Rate
Regimes
earlier versions of a 'managed float’. The exchange rate policy is guided by the
need to reduce excess volatility, prevent the emergence of speculative activities,
help maintain adequate reserves, and develop an orderly foreign exchange
market. The current exchange rate regime has been accompanied by full
‘Convertibility on current account’ with effect from August 20, 1994. Moving
forward, as India progresses towards full capital account convertibility and gets
more and more integrated with the rest of the world, managing periods of
volatility is bound to pose greater challenges given the impossible trinity of
independent monetary policy, open capital account and exchange rate
management. The principal features of the current exchange rate regime in India
can be stated as follows:
i) The rates of exchange are determined in the market.
ii) The freely floating exchange rate regime continues to operate within the
exchange control framework.
iii) RBI can intervene in the market to modulate the volatility and sharp
depreciation of the rupee.
iv) The US dollar is the principal currency for RBI transactions.
v) The RBI also announces a Reference Rate based on the quotations of select
banks in Bombay at noon every day. The Reference Rate applies to SDR
transactions and transactions routed through the Asia Clearing Union.

Check Your Progress 4

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Trace the historical development of the exchange rate regime in India.

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2) Discuss some of the features of the current exchange rate system in India.

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7.7 LET US SUM UP

In this unit we discussed about various exchange rate regimes. Exchange rate
regime is an integral part of every country’s economic and monetary policy. An
exchange-rate regime is a way an authority manages its currency in relation to
other currencies and the foreign exchange market. There are three types of
exchange rate systems globally: flexible or floating exchange rate systems, fixed
exchange rate systems and managed floating (intermediate exchange rate 149
Exchange Rate and
Balance of Payments system). Under fixed exchange rates, governments decide to fix their rates to
some other standard, either a dominant currency such as the dollar, or a basket of
currencies or gold. Under floating exchange rates, the market determines the
outcomes of rates. In a floating exchange rate regime the market’s demand for
and supply of the currency determines the exchange rate. There is no pre-
determined official target for the exchange rate set by the government. The latter
and/or the central bank can indirectly influence the exchange rate by managing
the level of domestic and foreign currencies in the banking system. In managed
exchange rate regimes, the value of the currency is determined to vary degrees by
government intervention. A country can alter the degree to which it intervenes in
the foreign exchange market. Managed float is also referred to as dirty float.
The exchange rate is the dominant target of economic policymaking.
Balance of payments on current account disequilibrium can automatically be
restored to equilibrium through a floating exchange rate regime and the scarcity
or surplus of any currency is eliminated. Balance of payment adjustment is
smoother and painless under a floating exchange rate regime compared to a fixed
exchange rate system. The autonomy of monetary authorities is preserved under a
floating exchange rate system as there is no target exchange rate to maintain.
Since 1971 exchange rate system is known as a non-system. This variety of
exchange rate regimes exists in today’s global financial environment.
The history of exchange rate regimes can be categorised into four parts in the
following way:
i) Before World War I (WWI) financial order (1870–1914)
ii) Inter-war period (1919–1939)
iii) The Bretton Woods system (1945-1971).
iv) The post-Bretton Woods system (1971–present): the non-system.
In the post-independence period, India's exchange rate policy has seen a shift
from a par value system to a basket-peg and further to a managed float exchange
rate system during the period 1947 to 1971. In March 1993 the system of the
market-determined exchange rate was adopted. However, the RBI did not
relinquish its right to intervene in the market to enable orderly control.

7.8 KEY WORDS

The black market for foreign is a market where foreign currencies are
exchange exchanged for the national currency of a
country at a premium over the rate at
which the value of the national currency is
pegged by its monetary authority. A black
market for foreign exchange is an outcome
of an over-valued pegged exchange rate
150
 regime together with binding exchange Exchange Rate
Regimes
control.
BoP crisis is a situation where foreign currency
reserves held by a country's central bank
dry up and the country defaults on
payment for its imports and debt
repayment. A BoP crisis emerged for India
in early 1991 when it had foreign currency
reserves that could barely finance a week’s
imports.
Clean float a regime where a country's monetary
authority does not intervene in the foreign
exchanges market in any way whatsoever
and allows the price of its own currency in
terms of a particular foreign currency to
adjust to market conditions.
Conventional Pegs are those in which the authorities intervene
to keep the exchange rate at a pre-arranged
level.
Convertibility of rupee on means the freedom to convert rupees into
capital account foreign currency and back for capital
transactions. It is a feature of a nation's
financial regime that centres on the ability
to conduct transactions of local financial
assets into foreign financial assets freely or
at country-determined exchange rates. It is
sometimes referred to as capital asset
liberation or CAC.
Convertibility of rupee on implies that the Indian rupee can be
current account converted to any foreign currency at
existing market rates for trade purposes for
any amount. Anyone who deals in the
current account means international trade
of goods and services can convert them to
Indian Rupees.
Crawling Pegs when the exchange rate is regularly
adjusted in the same direction by a pre-
arranged amount.
Currency Boards the regime under which the only role of
monetary policy is to keep the domestic
currency’s value constant relative to a
particular foreign currency. 151
Exchange Rate and
Balance of Payments Devaluation is a deliberate downward adjustment to the
value of a country's currency relative to
another currency, group of currencies or
standard. Devaluation is a monetary
policy tool used by countries that have
a fixed exchange rate or semi-fixed
exchange rate. It is often confused
with depreciation and is the opposite of
revaluation.
Dirty float is a currency that floats in value in terms
of other currencies but is not free of
government intervention. Governments
intervene to smooth fluctuations or
manage a desired exchange rate.
Dollarization involves one country unilaterally adopting
the currency of another.
Exchange control is a cap imposed by the monetary authority
of a country on foreign currency buying by
its domestic importers and other buyers.
Full Convertibility of rupee fully convertible, when there are no
current account or capital account
restrictions for free movement of funds
into and out of the country. As there are a
lot of restrictions for the free movement of
funds from India and also into the
country, Indian Rupee is not fully
convertible.
Gold standard was an international monetary system in
which gold was the reserve asset against
coins and currencies in circulation in
different countries. With the gold standard,
countries agreed to convert paper money
into a fixed amount of gold. A country that
uses the gold standard sets a fixed price for
gold and buys and sells gold at that price.
International currency system defines the parameters of the foreign
exchange market where national
currencies are exchanged and traded.
Managed Floating Rates these are the rates under which authorities
intervene to limit short-term currency
fluctuations without the goal to keep the
152 exchange rate at a certain level.
 Exchange Rate
Special Drawing Rights (SDRs) IMF created an international reserve asset Regimes
in 1969 to support the Bretton Woods
fixed exchange rate system. It is defined as
the weighted average of four major
currencies – euro, Japanese yen, pound
sterling, and USD.
The Bretton Woods system was a gold-USD exchange standard that
defined the international currency system
during 1944-71. Currencies of different
countries were pegged to the USD, which,
in turn, was convertible into gold at USD
35 per ounce.

7.9 SOME USEFUL REFERENCES

Acharyya, Rajat (2014): International Economics, Chapter 22, 1st edition, Oxford
University Press, New Delhi

Carbaugh, Robert J (2015): International Economics, Chapter 11, 11th edition,

Cengage Learning India Pvt. Ltd., New Delhi

Czinkota, Michael R et, al (2011): International Business, Cengage Learning

India Pvt. Ltd, India

Gowland, David (2012): International Economics, Chapter 9, Barnes and Noble

Books, Totowa, New Jersey, USA

Krugman, Paul R., Maurice Obstfeld, and Marc Melitz (2014): International
Economics: Theory and Policy, 10th edition, Pearson Education Ltd., New Delhi
Mark Stone, et, al, (2008): Exchange Rate Regimes, Finance and, Development,
IMF, March

Mulhearn, Chris, et. al, (2008): Economics for Business, Chapter 14, Palgrave,
New York, USA

Pugel, Thomas A (2016): International Economics, Chapter 17, 16th edition, Tata
McGraw-Hill Publishing Company, Ltd, New Delhi

Salvatore, Dominick (2004): International Economy, 8th edition, Wiley India Pvt.
Ltd., New Delhi

Sodersten, Bo and Geoffrey Reed (1994): International Economics, Chapter 17,

3rd edition, Palgrave MacMillan, London, UK.

153
Exchange Rate and
Balance of Payments 7.10 ANSWERS/HINTS TO CHECK YOUR
PROGRESS EXERCISES
Check your progress 1
1) see section 7.2
2) see section 7.2
3) see section 7.3

Check your progress 2

1) see sections 7.4.1 and 7.4.2
2) see sections 7.4.3 and 7.4.4

Check your progress 3

1) See section 7.5.1 and 7.5.2
2) See section 7.5.1 and 7.5.2
3) See section 7.5.3
4) See section 7.5.3 and 7.5.4
5) See section 7.5.2
6) See section 7.5.3 and 7.5.4
7) See section 7.5.3 and 7.5.4

Check your progress 4

1) See section 7.6
2) See section 7.6

154