Q.Discuss some of the exchange rate arrangements that countries have entered into to bring about stability in their external accounts.
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Start your 14-day free trial to unlock the full solution →Exchange rate arrangements are institutional frameworks that countries adopt to manage their currency's value relative to others, aiming to reduce volatility and stabilise external accounts. The key arrangements range from fully fixed (like a currency board) to fully floating, with several intermediate options — each with distinct implications for trade, capital flows, and policy autonomy.
The core problem any country faces in its external accounts is uncertainty. When the exchange rate swings wildly, exporters cannot plan their revenues, importers cannot budget their costs, and foreign investors get nervous about the value of their returns. This volatility can worsen a current account deficit or trigger sudden capital flight. To bring stability, countries have designed various exchange rate arrangements — each a different answer to the same question: how much freedom should the currency's price have?
Let us walk through the major arrangements, from the most rigid to the most flexible.
1. Fixed Exchange Rate System (Pegged Arrangement)
Under a fixed exchange rate, the central bank commits to keeping the domestic currency's value at a predetermined level against a major currency (usually the US dollar) or a basket of currencies. The central bank stands ready to buy or sell foreign exchange at that fixed price.
How it brings stability: By removing day-to-day exchange rate risk, it encourages trade and long-term investment. Exporters and importers know exactly what their foreign earnings or payments will be worth in domestic currency. This predictability can help reduce speculative attacks and stabilise the current account.
The catch: The central bank must hold large foreign exchange reserves to defend the peg. If the market believes the fixed rate is overvalued (say, because domestic inflation is higher than the anchor country's), speculators may attack the currency, forcing a devaluation. India operated a fixed exchange rate until 1991, pegged first to the pound sterling and later to a basket of currencies.
A fixed rate does not guarantee external stability by itself. If domestic inflation is persistently higher than the anchor country's, the real exchange rate appreciates, making exports uncompetitive and worsening the current account deficit. The peg then becomes a source of instability, not a cure.
2. Currency Board Arrangement
A stricter version of the fixed rate. The central bank issues domestic currency only when it has an equivalent amount of foreign reserves. Every rupee in circulation is backed by a dollar (or euro, etc.) in the vault. This removes the central bank's discretion to print money.
How it brings stability: It imposes hard discipline on monetary policy. Since you cannot print money without reserves, inflation stays low, and the exchange rate is virtually unbreakable. Countries like Hong Kong and Bulgaria have used this successfully.
The catch: The central bank loses its ability to act as a lender of last resort. If a domestic bank run occurs, the central bank cannot create liquidity to save it — because that would violate the currency board rule. This can make the financial system fragile.
3. Crawling Peg
Here, the exchange rate is fixed but adjusted periodically in small, pre-announced steps — typically to offset inflation differentials. The currency "crawls" from one peg to another.
How it brings stability: It allows a country with persistently higher inflation to avoid a sudden, disruptive devaluation. Instead of a one-time shock, the exchange rate adjusts gradually, giving traders and investors time to adapt. This was used by several Latin American countries in the 1980s and 1990s.
The catch: If the crawl is too slow relative to inflation, the real exchange rate appreciates and hurts exports. If too fast, it fuels inflation expectations. It requires careful calibration.
4. Managed Float (Dirty Float)
The exchange rate is largely market-determined, but the central bank intervenes occasionally to smooth out excessive volatility or to steer the rate towards a desired level. India has operated a managed float since 1993.
How it brings stability: The central bank can lean against speculative bubbles — buying rupees when the currency is under attack, selling dollars when it appreciates too fast. This prevents the wild swings that a pure float might produce, especially in a shallow forex market.
The catch: It requires the central bank to have good judgment about what "excessive" volatility means. If the market perceives the intervention as inconsistent or politically motivated, it can lose credibility.
The RBI does not target a specific exchange rate level under the managed float. Instead, it intervenes to contain volatility and to build reserves when inflows are strong. The exact intervention strategy is not publicly announced, which gives the RBI flexibility but also creates uncertainty for market participants.
5. Free Float (Pure Float)
The exchange rate is determined entirely by market forces of demand and supply. The central bank does not intervene at all. …
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