Exchange Rate Systems That Affect Market Behavior
Since an exchange operates in different types of exchange rate systems, it is fundamental to understand what these are. There are four main types of these exchange rate systems where an exchange rate can operate. Here is a description of the different types of exchange rate systems.
Fixed Exchange Rates System
It is true that every government will be interested in its currency's performance. A country's currency performance affects other markets in the economy. The exchange rate of that currency also becomes a reflection of economic performance, political conditions, and the general mood of a country's economy.
In this exchange rate system a government would exercise control over the exchange rate. Thus inducing or maintaining that country's exchange rate to a narrowed-down price range. Policies will be passed or direct-action (in the form of investments etc.) will be used to keep the exchange rate pegged at the desired range.
This exchange rate system has certain advantages. Exporters and importers have a more stable profitability. Normally there would be less speculation in this exchange rate system. This helps the import/export firms ensure that their sales would remain robust whatever the exchange rate is. The inflation rate would be kept to a minimum. And a steady price would attract more trade and investment.
Semi-Fixed Exchange Rate System
This system is pretty much like the fully fixed exchange rate system. In this exchange rate system currencies are allowed to move but only within a specified permitted range. Governments exercising this system would lend to economic policy making targeting the exchange rate. Interest rates may also be set to meet the targeted exchange rate.
In this exchange rate system there would be varying levels of control over exchange rates. There have been studies that show that in an economy of high capital mobility this system is unstable.
It allowed a country or a government that has poor monetary policy to exercise discretionary power overwhelmingly. Thus in cases like this, this exchange rate system would not be beneficiary to a government's economic system.
Free Floating Exchange Rate System
In a free floating exchange rate system the forces of supply and demand solely determine the value of the currency of a given country. Trade and capital flows directly affect forex market movements.
In contrast to fixed exchange rates a free floating exchange rate system allows exchange rates to move without the intervention from a national government. Market forces determine exchange rate movement. Changes and movements in market supply and demand cause changes in the value of currency.
Countries with large payments deficits may benefit from this system. This is due to the fact that fluctuations provide an automatic adjustment.
It also allows the monetary authorities in governments certain flexibility in interest rate determination. These would not be so concerned with influencing the exchange rate.
Managed Floating Exchange Rates System
This is the system that most governments would prefer. It is quite like a hybrid of the floating exchange rate and the fixed rate system. The government has a bit of leverage in this system. This system may also be a part of a fixed exchange rate system in a way.
Understanding how each system behaves and how they affect market movement would help a trader regarding planning and trading. Given all these systems a trader would be able to make profits whether a currency rate would either raise or drop depending on the profit making decisions they make.