Exchange Rate Systems and Currency Convertibility: Fixed, Floating, Managed Float and Pegs Questions

Question 1

Define exchange rate regime.

Accepted Answer

**Exchange rate regime** is the system/method by which a country determines and manages the value of its currency relative to other currencies.

Question 2

What is a fixed exchange rate system?

Accepted Answer

**Fixed exchange rate system** is a regime where a currency is pegged at a fixed parity (or narrow band) and the central bank intervenes to maintain it.

Question 3

What is a floating exchange rate system?

Accepted Answer

**Floating exchange rate system** is a regime where exchange rate is determined by market demand and supply without a fixed official parity.

Question 4

What is currency convertibility?

Accepted Answer

**Currency convertibility** means the freedom to convert domestic currency into foreign currency and vice versa for permitted transactions.

Question 5

What is managed float?

Accepted Answer

**Managed float (dirty float)** is a regime where the exchange rate mostly floats, but the central bank intervenes occasionally to reduce volatility or guide the rate.

Question 6

State one reason why countries use capital controls.

Accepted Answer

Countries use capital controls to reduce risk of **sudden capital outflows** and protect financial stability.

Question 7

Explain fixed exchange rate system (working) in brief (any three points).

Accepted Answer

### **Fixed Exchange Rate System (Working)**

- the government/central bank declares a **parity** (fixed rate) against another currency/basket.
- central bank intervenes using **forex reserves** to buy/sell foreign currency to keep the rate stable.
- monetary policy often supports the peg (interest rate changes to manage capital flows).

Thus, fixed rates give stability but require reserves and policy discipline to defend the peg.

Question 8

Explain floating exchange rate system (any three points) with a small table of merits/demerits.

Accepted Answer

### **Floating Exchange Rate System**

- exchange rate is determined by **demand and supply** in forex market.
- central bank does not commit to a fixed parity; rate can change daily.
- helps automatic adjustment to BoP shocks but can create volatility.

Mini table:

| Aspect | Floating |
|---|---|
| Merit | **automatic adjustment**, policy independence |
| Demerit | **volatility** and uncertainty for traders |

Hence, floating provides flexibility but requires good risk management by businesses.

Question 9

Differentiate fixed and floating exchange rate systems (any three points) with a table.

Accepted Answer

### **Fixed vs Floating Exchange Rate Systems**

- fixed gives stability; floating gives flexibility.
- fixed needs **reserve intervention**; floating relies on market forces.
- fixed reduces monetary policy independence; floating provides more policy independence.

Table:

| Basis | **Fixed** | **Floating** |
|---|---|---|
| Rate | official parity | market-determined |
| Reserves need | high | lower |
| Volatility | low | higher |

Thus, the choice depends on country priorities: stability vs flexibility.

Question 10

Explain pegged exchange rates and list types of pegs (any three) with examples.

Accepted Answer

### **Pegged Exchange Rate**

A **peg** means fixing the currency value to a reference currency or basket.

Types (any three):
- **single-currency peg**: peg to one currency (e.g., USD).
- **basket peg**: peg to weighted basket of currencies.
- **crawling peg**: peg adjusted gradually over time.

Hence, pegs provide stability but need reserves and credible policy to maintain.

Question 11

Explain merits and demerits of fixed exchange rate system (any three points) with a table.

Accepted Answer

### **Fixed Exchange Rate System: Merits and Demerits**

Merits (any three):
- provides **exchange rate stability** and reduces uncertainty for trade.
- supports inflation control if pegged to a stable currency.
- improves confidence for international contracts and investment.

Demerits (any three):
- needs large **forex reserves** to defend the peg.
- reduces **monetary policy independence**.
- may become overvalued/undervalued leading to BoP pressure and speculative attacks.

Table:

| Side | Points |
|---|---|
| **Merits** | stability, lower uncertainty |
| **Demerits** | reserve drain, policy constraints |

Thus, fixed rates give stability but can be costly to maintain during shocks.

Question 12

Explain current account convertibility vs capital account convertibility (exam-style) with a table.

Accepted Answer

### **Current vs Capital Account Convertibility — Exam-Style**

**Currency convertibility** means freedom to exchange domestic currency with foreign currency for allowed transactions.

#### **Current account convertibility**
- allows conversion for **trade in goods/services** and routine payments (remittances, interest, dividends).

#### **Capital account convertibility**
- allows conversion for **capital flows** (FDI, portfolio investment, loans, purchase of foreign assets).

Table:

| Feature | **Current account** | **Capital account** |
|---|---|---|
| Purpose | trade & routine payments | investment/borrowing flows |
| Risk | relatively lower | higher (sudden outflows) |
| Controls | usually fewer | often more controls in developing countries |

**Conclusion:** Many countries allow current account convertibility but manage capital account carefully to reduce financial instability.

Question 13

Explain managed float (dirty float): meaning, reasons and limitations (exam-style) with a flowchart.

Accepted Answer

### **Managed Float (Dirty Float) — Exam-Style**

**Meaning:** Managed float is a hybrid regime where exchange rate is largely market-determined, but the central bank intervenes sometimes.

#### **Reasons for intervention**
- reduce excessive **volatility** and speculative pressure.
- avoid sharp depreciation (imported inflation) or sharp appreciation (export loss).
- maintain orderly market conditions.

#### **Limitations**
- too much intervention can again require high reserves.
- market may become uncertain if policy signals are unclear.

Flowchart:

```text
Market sets rate → excessive volatility/speculation → central bank buys/sells forex → volatility reduces → market continues to guide rate
```

**Conclusion:** Managed float balances flexibility with stability, and is widely used by many emerging economies.

Question 14

Explain capital controls: objectives and pros/cons (exam-style) with a table.

Accepted Answer

### **Capital Controls**

**Meaning:** Capital controls are restrictions on cross-border **capital flows** (inflows/outflows).

Objectives (any three):
- reduce risk of sudden outflows and protect **forex reserves**.
- reduce excessive exchange-rate volatility and financial instability.
- retain some monetary policy space.

Table:

| Pros | Cons |
|---|---|
| stability, crisis prevention | distortions, lower investor confidence |

Thus, capital controls can be useful for stability, but overuse can hurt long-term efficiency and investment.

Question 15

Explain the role of central bank in exchange rate management (exam-style) with a flowchart.

Accepted Answer

### **Role of Central Bank in Exchange Rate Management — Exam-Style**

The central bank influences exchange rate through intervention, reserves management and policy signals.

Key roles:
- **intervention**: buy/sell foreign currency to smooth volatility or defend a peg.
- **reserve management**: maintain adequate forex reserves for stability.
- **monetary policy**: interest rate decisions influence capital flows and currency demand.
- **communication**: guidance to stabilize expectations.

Flowchart:

```text
FX pressure/volatility → central bank action (intervene / adjust policy / communicate) → stabilize market expectations → smoother exchange rate movement
```

**Conclusion:** Central banks play a crucial role in stabilizing currency and maintaining confidence, especially under fixed or managed regimes.

Exchange Rate Systems and Currency Convertibility: Fixed, Floating, Managed Float and Pegs

Fixed Exchange Rate System (Working)

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