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Level 2 Markets - History Of Exchange Rates

Current Exchange Rates
After the Bretton Woods system broke down, the world finally adopted the use of floating foreign exchange rates during the Jamaica agreement of 1976. This meant that the use of the gold standard would be permanently abandoned. However, that doesn't mean that governments adopted a purely free-floating exchange rate system. Most governments today use one of the following three exchange rate systems:

  • Dollarization
  • Pegged rate
  • Managed floating rate

Dollarization
Dollarization occurs when a country decides not to issue its own currency and uses a foreign currency as its national currency. Although dollarization usually allows a country to be seen as a more stable place for investment, the downside is that the country's central bank can no longer print money or control the country's monetary policy. One example of dollarization is El Salvador's use of the U.S. dollar. (To read more, see Dollarization Explained.)

Pegged Rates
Pegging is when one country directly fixes its exchange rate to a foreign currency so that the country will have somewhat more stability than a normal float. More specifically, pegging allows a country's currency to be exchanged at a fixed rate. The currency will only fluctuate when the pegged currencies change.

For example, China pegged its yuan to the U.S. dollar at a rate of 8.28 yuan to US$1, between 1997 and July 21, 2005. The downside to pegging is that a currency's value is at the mercy of the pegged currency's economic situation. For example, if the U.S. dollar appreciates substantially against all other currencies, the Chinese yuan will also appreciate, which may not be what the Chinese central bank wants, since China relies heavily on its low-cost exports.

Managed Floating Rates
This type of system is created when a currency's exchange rate is allowed to freely fluctuate subject to supply and demand. However, the government or central bank may intervene to stabilize extreme fluctuations in exchange rates. For example, if a country's currency is depreciating very quickly, the government may raise short-term interest rates. Raising rates should cause the currency to appreciate slightly; but understand that this is a very simplified example. Central banks can typically employ a number of tools to manage currency.

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