Understanding Exchange Rate Systems

An exchange rate system is the set of rules that governs how a country's currency exchange rate is determined vis-à-vis other currencies. Different systems exist, primarily categorized by the degree of government intervention.

Types of Exchange Rate Systems

Let's examine the different exchange rate systems mentioned in the options:

• Fixed Exchange Rate System: In this system, the government or the central bank officially fixes the exchange rate of its currency against another currency, a basket of currencies, or a commodity like gold, at a specific level. The government then intervenes in the foreign exchange market to maintain this fixed rate.
• Floating Exchange Rate System: Also known as the Flexible Exchange Rate System, here the exchange rate is determined by the forces of demand and supply in the foreign exchange market, with minimal or no government intervention. Fluctuations occur freely based on market conditions.
• Managed Floating Exchange Rate System: This system is a hybrid of fixed and floating systems. The exchange rate is primarily determined by market forces, but the central bank reserves the right to intervene in the market to smooth out excessive fluctuations or steer the rate towards a desired level.

Analyzing the Question

The question asks for the exchange rate system where the government fixes the exchange rate at a particular level. Based on our understanding of the different systems:

• The Fixed Exchange Rate System is defined by the government setting and maintaining a specific exchange rate.
• The Floating Exchange Rate System (or Flexible) is driven by market forces, not government fixing.
• The Managed Floating Exchange Rate System involves market forces but with government intervention to manage volatility, not to fix the rate rigidly at a level.

Therefore, the system where the government fixes the exchange rate is the Fixed Exchange Rate System.

Conclusion

The system described in the question, where the government fixes the exchange rate, is the Fixed Exchange Rate System.

Revision Table: Exchange Rate Systems

Additional Information: Implications of Fixed Exchange Rates

A fixed exchange rate system offers certain advantages and disadvantages:

• Advantages:
  • Provides certainty for international trade and investment by reducing exchange rate risk.
  • Can help control inflation if pegged to a country with lower inflation.
  • Imposes discipline on monetary policy as maintaining the peg requires stable domestic conditions.
• Disadvantages:
  • Requires significant foreign exchange reserves to defend the peg.
  • Limits a country's ability to use independent monetary policy for domestic goals (like managing unemployment).
  • Can be vulnerable to speculative attacks if the market believes the peg is unsustainable.

Maintaining a fixed exchange rate often involves the central bank buying or selling foreign currency in the market to keep the domestic currency's value at the target level. If the domestic currency is depreciating below the target, the central bank sells foreign currency (and buys domestic currency) to increase demand for the domestic currency. If it's appreciating too much, the central bank buys foreign currency (and sells domestic currency).