Exam 11: The International Monetary and Financial Environment

Correct Answer:

Verified

a. Floating Exchange Rate System-Under this system, governments refrain from systematic intervention and each nation's currency floats independently, according to market forces. Major world currencies-including the Canadian dollar, the British pound, the euro, the U.S. dollar, and the Japanese yen-float independently on world exchange markets. Their exchange rates are determined daily by the forces of supply and demand.
b. Fixed Exchange Rate System-The value of a currency is set relative to the value of another (or to the value of a basket of currencies) at a specified rate. The system is sometimes called a pegged exchange rate system. As the reference value rises and falls, so does the currency pegged to it. Many developing economies and some emerging markets use this system today. For example, China pegs its currency to the value of a basket of currencies, and Belize pegs the value of its currency to the U.S. dollar. To maintain the peg, the governments of these countries intervene in currency markets to buy and sell dollars and other currencies, in order to maintain the exchange rate at a fixed, preset level.
The benefit of the floating exchange rate system is that governments have the latitude to modify monetary policy to fit the circumstances that they face at any time. If a country is running a trade deficit, the floating rate system allows for this to be corrected more naturally than if the country uses a fixed exchange rate regime. The benefit of the fixed exchange rate system is that it offers greater stability and predictability of exchange rate movements and promotes greater certainty and stability within a nation's economy.