The exchange rate system is an important part of each country’s economic and monetary policy, and requires the use of a common language in exchange rate discussions. The following classification is important in this sense. There are two main exchange rate systems: fixed and flexible exchange rate system. Additionally, there is an intermediate exchange rate system between these two opposing exchange systems, formed according to the changing needs of the countries. The unique features of each exchange system, the advantage-disadvantage of the stability of the country’s economy plays a decisive role. Therefore, the choice of the right exchange rate system is important for the financial stability of the countries.
According to the IMF’s report on exchange rate arrangements covering 189 members, the distribution of exchange rates between countries in 2017 is given in the Chart below. Accordingly, 42% of 189 countries prefer intermediate exchange rates, while 39% apply flexible rates. Fixed rate is applied by 12% of the countries. As can be seen here, a transition to more flexible exchange rates is made. Fixed exchange rates are abandoned, and flexible exchange rates are preferred. They are more appropriate to the monetary policies of countries However, countries do not want to leave control by adopting the transition to free exchange rate regime. This slows down the transition to the free floating system.
When the literature is examined, financial integration, macroeconomic performance and views on financial sector development are effective in the selection of exchange rates. One of the most common views is that the fixed exchange rate of countries that are closely related to the global financial markets is unsustainable. This vision, also known as the trilemma, predicts that a country can choose two of its objectives for independence, monetary policy independence or integration in global financial markets. It is stated that the country will have to sacrifice one of these three if country tries to achieve these three objectives. In the 1990s, many countries had to abandon an adjustable fixed exchange rate regime, and the exchange rates could not be sustained and resulted in a crisis. Another view relates to the hypothesis of fluctuation fear. According to this view, many countries that implement a flexible exchange rate system are also intertwined with the fear of fluctuation in exchange rates. They regularly intervene to sterilize the exchange rate. Another reason for demanding a fixed exchange rate is the uncertainty created by the flexible exchange rate system. This kind of risk discourages international trade and investments. The fixed exchange rate gives confidence to the international investor, decreasing the exchange rate risk and encouraging international trade and investments. Also the fixed exchange system helps in preventing speculative bubbles.
The flexible exchange rate system also helps the country to implement independent monetary policy. Contrary to the fixed exchange rate, the government can easily implement policies in any way to reduce demand and thus go to recession. With the free exchange rate, the country responds to recession with the growth in money supply and the depreciation of money. This encourages domestic demand, the economy returns to the desired levels of employment. Another advantage of the flexible setup is the automatic adaptation mechanism against commercial shocks. Money responds positively to developments in the country’s export market, with the change in the value of money and trade. The flexible exchange rate system ensures economic efficiency and discipline by operating market conditions to the maximum. In flexible exchange rate systems, the value of national currency is an important economic indicator. If the money of the country is gaining value, the trust of the investors is ensured; The flexible exchange rate system provides better financial stability than the fixed rate. It is not necessary for the speculators to test the determination of a dry protection determined by the state in the flexible exchange rate regime. The flexible setup system may not always be implemented. If the economy is very vulnerable to frequent and varied exchange rates, it may not be possible to implement the flexible exchange rate system if domestic and foreign investors consider the exchange rate stability and the predictability of the exchange rate because of previous financial crises and high inflation, or if the monetary authority does not inspire confidence that the foreign exchange market will not interfere.