The foreign exchange rate system can be broadly divided into two systems: the fixed exchange rate system and the floating exchange rate system. First, let us review a little about what the fixed exchange rate system is.
The fixed exchange rate system was a system in which the dollar and yen exchange rate (price) was firmly “fixed” to “1 dollar = how many Canadian dollar(s)”. Under this system, a predetermined amount of money is available, so the world’s money transactions can be carried out with peace of mind.
However, this system relied on the power of the United States, a country in an “absolute position” of power both politically and economically. In other words, the US dollar as the American currency was used as the center of the world’s currency (the key currency), and they were firmly linked. This also combined the value of the dollar with gold in order to make the US domestic currency the international currency used for world trading, and many countries decided to use the dollar as a key currency.
What is the mechanism of the floating exchange rate system?
Every system has pros and cons, the same applies to the floating exchange rate system, which is the center of the world economy. Not surprisingly, the world economy, which was based on a fixed exchange rate system, adopted a floating exchange rate system in order to clear the deadlock, but the world generally did not agree that the floating exchange rate system was the best system. Therefore, let us consider the positive points of the floating exchange rate system.
Benefits of Floating exchange rate system
Major countries in the world decided to abandon the “fixed exchange rate system” and shift to the “floating exchange rate system”. Floating exchange rates can be broadly divided into two forms. The first is a free-floating exchange rate system – in the foreign exchange market, the exchange rate is completely determined by the supply and demand of foreign exchange. The second is a managed floating exchange rate system – this is a system that assumes that the currency authorities will intervene in the foreign exchange market and manipulate the exchange rate in order to prevent the exchange rate from deviating significantly from the existing standards.
- Under the floating exchange rate system, it is possible that the external imbalance of a country will be automatically resolved. For example, when the Canadian balance of payments goes into the black, a large inflow of dollars will occur in the Canadian foreign exchange market. As a result, the dollar will weaken and the Canadian dollar will appreciate, and this appreciation will curb the demand for Canadian goods from overseas, resulting in a decrease in Canadian exports. In other words, it is thought that the large surplus of Canadian balance of payments in the early stages, will be automatically eliminated under the floating exchange rate system. This is called the automatic adjustment mechanism of the floating exchange rate system, and it is considered a great merit of the floating exchange rate system.
- With a floating exchange rate system, speculative capital inflows may be small. This speculative inflow of capital means foreign investment coming in to take advantage of sudden fluctuations in exchange rates. For example, global “investment funds” and “institutional investors” who manage huge amounts of money inject a large amount of money at once in order to seek profit from fluctuations in the exchange rate of a certain country. This speculative capital is also called hot money.
- Fluctuations in foreign exchange rates will theoretically automatically balance the payments of a country, so the government of that country will not need to worry about the balance of payments. In other words, the advantage of the floating exchange rate system is that the government of the home country should instead focus on overcoming the inward equilibrium (inflation and deflation) in the home country.
- Since the exchange rate is automatically adjusted by the foreign exchange rate, the currency authorities of a country do not need to have the funds to return the exchange rate to the way it should be, that is, there is no need for intervention funds. Therefore, one of the advantages of the floating exchange rate system is that you do not need to have much in the way of foreign currency reserves.
There are other advantages as well, but experts who have defended the floating exchange rate system have said that the floating exchange rate system is, so to speak, “all good things”. However, it cannot be said that only “good things” are happening all the time, and the advantages of the floating exchange rate system mentioned above are not particularly effective. The world also seems to be in turmoil in comparing both systems.