Explain the Flexible Exchange Rate System


The articles of the IMF were amended in 1978 (second amendment) to provide them the
authority to introduce a new exchange rate system which was not based on fixed gold
valuation. The IMF proposed the Flexible Exchange Rate System. The main features of
this system were as follows:
1. Every member country was free to adopt any exchange rate mechanism of its choice.
2. The concept of valuing currencies against gold was abolished.
3. Each member country was required to undertake to maintain stability in their
exchange rate.
4. Each member country was required to undertake to maintain orderly conditions in their
domestic foreign exchange markets. 5. Every member country was required to accept
the supervisory authority of the IMF in relation to the exchange rate management system
and their surveillance over the domestic foreign exchange market.
There are two primary models of currency management used to maintain the
exchange rate under this particular system. They are:
Clean Float or Free Float: It is a model under which there is no official participation in
establishing currency values. The central bank does not set any target range or price and
the value of a currency is determined by market forces of demand and supply. The Central
Bank or the Government does not participate in the establishment of the exchange rate.
The disadvantage of this system was that currencies of weaker economies became
vulnerable to speculative attacks but most major economies floated their currencies.
Managed or Dirty Float: Most medium and small economies, therefore adopted the
system of PEGGING their currency either to one of the major international currencies or
SDR’s or a basket of currencies. The disadvantage of this mechanism was that the
exchange rate of a country did not reflect the economic fundamentals of the home country,
but its value depended upon the economic performance of the country to whose currency
the domestic currency was pegged.

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