Class 12 Macro Economics Notes · CBSE
Types of Exchange Rate Systems
Fixed exchange rate system with merits and demerits, devaluation vs depreciation, flexible exchange rate system, and managed floating rate system with RBI intervention. CBSE Class 12 Macroeconomics notes.
Last updated: 1 Sep 2026
Notes
Fixed Exchange Rate System
- The government buys or sells foreign currency in the market to maintain the fixed rate.
- It requires the central bank to hold huge foreign exchange reserves.
- The fixed rate is maintained through an External Standard such as gold, silver, or another currency.
- This system is also called Pegging, where the currency is tied to another currency or a basket of currencies.
- The Parity Value refers to the officially declared value of the currency in terms of foreign currency.
Fixed Exchange Rate System
Advantages
- Provides stability and certainty in international trade
- Promotes foreign investment due to predictable returns
- Encourages trade by reducing exchange rate risk
- Prevents speculative activities in the foreign exchange market
- Facilitates coordination of macroeconomic policies across countries
Disadvantages
- Requires huge foreign exchange reserves to maintain the rate
- Difficult to fix the exact rate appropriate for the economy
- Not permanently fixed — governments may change it under pressure
Historical Fixed Rate Systems
Gold Standard (1870–1914): Under this system, currencies were fixed by the price of gold. For example, if £1 = 5 grams of gold and $1 = 2 grams of gold, then £1 = $2.50. Every currency had a fixed value in terms of gold.
Bretton Woods System (1944–1971): After World War II, the US dollar was made the central element of the international monetary system. All currencies were pegged to the US dollar, and the dollar was convertible to gold. This system led to the establishment of the International Monetary Fund (IMF).
Devaluation and Revaluation
| Aspect | Devaluation | Depreciation |
|---|---|---|
| Meaning | Government-induced reduction in the value of domestic currency | Market-induced fall in the value of domestic currency |
| Occurrence | Occurs due to deliberate government action | Occurs due to market forces of demand and supply |
| Exchange Rate System | Happens under a Fixed Exchange Rate System | Happens under a Flexible Exchange Rate System |
Flexible Exchange Rate System
- The value of the currency fluctuates freely in response to changes in demand and supply.
- There is no government or central bank intervention to fix the exchange rate.
- The rate is determined by the interactions of buyers and sellers in the foreign exchange market.
Flexible Exchange Rate System
Advantages
- Maintains equilibrium between demand and supply of foreign exchange
- No requirement to hold huge foreign exchange reserves
- Leads to optimum utilisation of resources as rates reflect true market value
Disadvantages
- Leads to instability in the exchange rate
- Encourages speculative activities in the market
- Creates inflationary situations due to frequent fluctuations
Fixed Exchange Rate vs Flexible Exchange Rate
| Aspect | Fixed Exchange Rate | Flexible Exchange Rate |
|---|---|---|
| Determination | Officially fixed by the government | Determined by market forces of demand and supply |
| Government Control | Complete government control over the exchange rate | No government control; market determines the rate |
| Stability | Relatively stable over time | Frequently changes with market conditions |
| Foreign Exchange Reserves | Required to maintain the fixed rate | Not required as the market self-corrects |
| Currency Value Changes | Changes through devaluation or revaluation | Changes through depreciation or appreciation |
Managed Floating Rate System
- It is a mixture of both flexible and fixed exchange rate systems.
- The exchange rate is determined by market forces of demand and supply.
- The central bank manages the rate through intervention in the foreign exchange market.
- The intervention limits excessive fluctuations in the exchange rate.
- The central bank maintains foreign exchange reserves for this purpose.
- Also known as Dirty Floating (when the central bank intervenes) as opposed to Clean Float (pure market determination).
Target Range
Clean Float vs Dirty Float
Clean Float: A pure floating exchange rate system where the rate is determined entirely by the forces of demand and supply with absolutely no intervention by the central bank or government.
Dirty Float: A floating exchange rate system where the rate is primarily determined by market forces, but the central bank occasionally intervenes to stabilise the currency or prevent excessive volatility. This is the system used by most countries today, including India.