CDS (I) 2021 General Knowledge · Question 28 of 120

Correct — B, Fixed exchange rates are rates set by Government decisions and maintained by Government actions. Both halves of that sentence are right, and the second half is the one candidates forget. The textbook definition covers the first: in a fixed exchange rate system the government fixes the exchange rate at a particular level. Fixing a price, however, does not make the market clear at it. If the announced rate leaves an excess supply of foreign currency the authorities must buy the surplus, and if it leaves an excess demand they must sell foreign currency out of their reserves — and if they cannot, a black market appears. So a fixed rate is maintained by continuous official action, and it survives only as long as the market believes the reserves are sufficient. Where that belief fails, aggressive selling of the currency forces a devaluation, which is the pattern seen before the collapse of the Bretton Woods system. Under a fixed regime, an official move that raises the exchange rate and makes the domestic currency cheaper is called devaluation, and a move the other way is revaluation.

• (a)Floating exchange rates are rates in which the Governments interfere by buying or selling their currencies. — Describes managed floating rather than floating. A flexible or floating rate is determined by the market forces of demand and supply, and in a completely flexible system central banks do not intervene in the foreign exchange market at all. The system in which they do intervene to moderate movements is called managed floating, or dirty floating, and it is the arrangement most of the world including India actually uses.
• (c)Under the Bretton Woods System, the exchange rates are floated in terms of rise or fall in price of gold. — Reverses what that system was. Bretton Woods, agreed at the United Nations Monetary and Financial Conference of 1944 which also created the IMF and the World Bank, was a system of pegged rates, not floating ones — members held par values against the United States dollar, and the dollar alone was convertible into gold at a fixed official price. Rates did not float with the price of gold; the whole design was to stop them moving.
• (d)Under the classical gold standard, the exchange rates are fixed in terms of price of dollar. — Puts the dollar where gold belongs. Under the classical gold standard each currency was defined as a fixed quantity of gold, and the exchange rate between any two currencies followed arithmetically from the ratio of those gold contents. The dollar-centred arrangement came later, with Bretton Woods, so this option describes the wrong era.

There are three ways a country can settle the external price of its money. It can let the market decide, which is the flexible or floating rate. It can announce a rate and defend it with reserves, which is the fixed rate. Or it can float but intervene when movements look excessive, which is managed floating — described as a mixture of the float part and the managed part, and the arrangement the world moved to without any formal international agreement after Bretton Woods ended. Each choice trades something away: a fixed rate buys predictability at the cost of monetary independence and large reserves, while a float returns monetary independence and lets the rate absorb balance of payments shocks by itself.

Every option here is a definition with one element swapped, so the item rewards checking each sentence against the property that defines the regime it names. Two habits help. First, remember that intervention is the signature of a managed float, so any sentence that pairs 'floating' with 'governments buying and selling' has misnamed itself. Second, keep the two historical systems in order — gold first, with currencies defined in gold; then Bretton Woods from 1944, with currencies pegged to the dollar and the dollar tied to gold; then the general float from the early 1970s. India's own rate is a managed float, with the Reserve Bank intervening to smooth volatility rather than to defend a level, which is why the rupee moves from day to day but rarely in jumps.

• In a fixed exchange rate system the government fixes the rate at a particular level and must buy or sell foreign currency to hold it there.
• A raising of the exchange rate by official action under a fixed system is devaluation; a lowering is revaluation.
• A flexible or floating rate is set by market demand and supply, and in a completely flexible system central banks do not intervene.
• Managed floating, also called dirty floating, mixes the two — central banks intervene to moderate movements when they judge it appropriate.
• The Bretton Woods system, agreed at the 1944 United Nations Monetary and Financial Conference that established the IMF and the IBRD, was a pegged-rate system centred on the United States dollar.
• Under the classical gold standard each currency was defined as a fixed weight of gold, and exchange rates followed from those gold contents.

• Calling intervention a feature of floating rates; it is the feature of managed floating.
• Describing Bretton Woods as a floating system when it was built to hold rates fixed.
• Putting the dollar at the centre of the classical gold standard, where gold itself was the anchor.
• Using devaluation and depreciation interchangeably; the first is an official act under a fixed rate, the second a market movement.

As a which-statement-is-correct item on exchange rate regimes, or as a statements question on what determines the external value of a currency.

• practice — not a real PYQ

  An exchange rate system in which the market determines the rate but the central bank intervenes to moderate large movements is called

  • (a)a completely flexible exchange rate
  • (b)a fixed exchange rate
  • (c)managed floating
  • (d)the gold standard

  Answer(c) managed floating — also called dirty floating, it mixes a market-determined rate with official intervention, and it is the arrangement most countries use today.

• practice — not a real PYQ

  Under a fixed exchange rate system, an official action that makes the domestic currency cheaper in terms of foreign currency is termed

  • (a)depreciation
  • (b)devaluation
  • (c)revaluation
  • (d)appreciation

  Answer(b) devaluation — depreciation is the equivalent movement under a floating rate, brought about by the market rather than by an official decision.