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Forex: Alternative Exchange Rate Systems

In 1944, the participants in the Bretton Woods conference, where the IMF Articles of Agreement were worked out, faced with a choice between several possible exchange rate systems: freely floating rates of exchange, flexible exchange rate systems, fixed parities, absolutely fixed parities, and a system with multiple exchange rates.

However, all fixed parities are actually subject to change from time to time. Rigid, unadjustable parities may exist on theory, but they are seldom found in peacetime practice. That is why the Bretton Woods system of fixed parities was often called the adjustable-peg system.

Under a freely floating system, the rate of exchange is established on the foreign exchange markets without government intervention. There is usually no fixed parity under the system; the only prevailing rate is usually that established by supply and demand forces on free markets.

Such a rate of exchange is often termed the 'natural' or market rate. Theoretically, the freely floating system does not require holdings of international reserves, since no attempt is made to control the movement of exchange rates and government intervention on the exchange market is not involved.

When a system of flexible exchange rates prevails, parity is usually not established and the rates are determined by the market. However, the government reserves the right to intervene from time to time in an effort to increase or decrease the ra

Flexible rates require some holdings of international reserves; for the government's central bank or exchange stabilization institution could not intervene on the exchange markets without them.

Under a system of adjustable fixed pars, parity is established, as it was under the 1944 IMF Agreement, and is subject to adjustment from time to time. The market rates of exchange are permitted to fluctuate above and below par in either a wide or a narrower band.

The fixed par system, which is still in general use, requires substantial holdings of international reserves; their actual amount is partially determined by the size of the permitted band of fluctuations around par and the individual country's requirements.

A system of rigidly fixed parities, not subject to adjustment, and no permitted exchange rate fluctuations around then implies all-embracing exchange controls. The relatively free exchange market is abolished, and a monopoly of foreign exchange dealings is conferred on the central bank or an exchange stabilization institution.

All buyers of exchange must purchase it from that institution, and all those who receive foreign exchange must turn it over to that institution in exchange for domestic currency. Under such a system, no intentional reserves are required theoretically, although most nations that use complete exchange control do hold some. Such systems may be used in wartime.

Multiple exchange rate systems lie somewhat outside the spectrum already sketched. Under such systems, and there are many types of them, no single rate or parity, either in fact or in effect, is applicable to all transactions.

Thus, a country might have two official parities, a lower one in terms of the domestic currency that is applicable to exports and a higher one that is applicable to imports. Such a system would encourage exports, and discourage imports. Also, the government would earn revenue by buying foreign currencies cheaply and selling them dearly.