Exchange rate system
Exchange rates are governed by the host country's exchange rate systems. In light of the floating exchange rate. The value of a country's currency can move freely based on the factors described above. Under a fixed rate system, the host government attempts to change the interest rate or buy and sell foreign currencies to maintain a fixed value against the US dollar, the euro, or a basket of currencies. This is called linking the value of one currency to another. Between 1945 and 1971 under the Bretton Woods system. The US dollar was tied to a certain amount of gold. All other currencies were linked to the US dollar. This system ended in 1971 when many countries decided to allow their currencies to float.
The concept of the impossible trilogy
A country cannot do what it wants with its currencies. There is a concept called the impossible trilogy, which says that any government only has two of the following three options:
- Independent monetary policy.
- Fixed exchange rates.
- Absence of capital controls.
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| Currency exchange rate system |
For example: If a country chooses a fixed exchange rate, it must give up pursuing an independent monetary policy. Or it imposes capital controls to maintain the stability of its currency's correlation against the other independent currency. If a country decides to maintain a currency peg during volatile periods, maintaining a fixed rate becomes expensive. When the established system begins to fail, as happened in Mexico in 1994 and Southeast Asia in 1998, a currency crisis occurs with currencies falling to their true levels, causing the disruption of trade and investment.
