Page 32 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 2: International Monetary System

Pegged exchange rate systems: In this system, currency values are fixed in relation to Notes
another currency such as the US dollar, Euro or to a currency basket such as the Special
Drawing Right (SDR). SDR are an international reserve created by the IMF and allocated to
member countries to supplement foreign exchange reserves.

Did u know? The basic disadvantage of a pegged system is that central banks must fight
the market to maintain the system even if inflation rates in two countries are the same.
There is still a probability that currencies will undergo significant change in market value
and “fall out” of a pegged exchange rate system.
Limited flexibility exchange rate systems: The limited flexibility category consists of two
groups. The first group includes several gulf countries with currencies that have shown
limited flexibility in terms of the US dollar. The governments of these oil-producing
countries have been able to maintain limited flexibility against the dollar because their
major export is oil and oil is priced around the world in US dollars.
The second group is comprised of countries in the European Exchange Rate Mechanism
(ERM). During 1998, the ERM was a cooperative arrangement in which currency values
were managed around a control rate called the European Currency Unit (ECU), a basket of
currencies weighted by each members proportion of intra European trade and gross national
product.

The limited flexibility exchange rate system attempts to combine the best of the fixed
(pegged) period and floating rate (more flexible) systems. First, the short-term currency
risk was reduced because foreign exchange rates tended to remain relatively stable within
the ERM. Second, as the ERM has an allowable band for movement around the central ECU
rate, the system did not need the highly restrictive monetary policies that accompany a
fixed exchange rate system. If for some reason a currency would fall below its ERM floor,
European central banks would cooperate in buying the currency in an attempt to keep it
within its ERM band.

Self Assessment

Fill in the blanks:

9. In …………………… system, currency values are fixed in relation to another currency such
as the US dollar, Euro or to a currency basket such as the special drawing right (SDR).
10. …………………… are an international reserve created by the IMF and allocated to member
countries to supplement foreign exchange reserves.
11. The basic disadvantage of a pegged system is that central banks must fight the market to
maintain the system even if …………………… rates in two countries are the same.

Task “Dollar has a very prominent position in the world trade today.” Do you agree?
Elucidate with example.

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