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Exchange rate systems sit at the heart of Unit 6's open economy framework—they determine how currencies interact, how trade flows adjust, and whether countries can pursue independent monetary policy. When you're analyzing the foreign exchange market or explaining how net exports respond to currency changes, you need to understand why a country's currency behaves the way it does. That behavior depends entirely on which exchange rate system the country uses.
You're being tested on the trade-offs countries face: stability versus flexibility, monetary independence versus currency credibility. The AP exam loves asking how central bank interventions affect exchange rates, or why a country might sacrifice monetary policy control for price stability. Don't just memorize which countries use which systems—know what each system gains and gives up, and how it connects to the AD-AS model, monetary policy effectiveness, and balance of payments adjustments.
These systems let supply and demand in the foreign exchange market set currency values. The key principle: when market forces determine exchange rates, currencies automatically adjust to trade imbalances and inflation differentials—but volatility is the trade-off.
Compare: Floating vs. Managed Float—both rely on market forces for price discovery, but managed floats allow central bank intervention during extreme volatility. If an FRQ asks about "how most major economies manage their currencies today," managed float is your answer.
These systems require active government commitment to maintain a specific exchange rate. The core trade-off: fixed rates provide price stability for international trade but require surrendering monetary policy independence and holding substantial foreign reserves.
Compare: Fixed Rate vs. Currency Board—both maintain fixed exchange rates, but a currency board provides stronger credibility by requiring 100% foreign reserve backing. The trade-off is even less monetary flexibility. Currency boards represent the most extreme commitment short of abandoning your currency entirely.
When countries go beyond pegging and actually adopt another currency or create a shared one, they completely surrender monetary sovereignty. The benefit is eliminating exchange rate risk entirely; the cost is losing all ability to tailor monetary policy to domestic conditions.
Compare: Dollarization vs. Euro adoption—both eliminate exchange rate risk and surrender monetary policy, but Euro countries collectively influence ECB policy while dollarized countries have zero input into Fed decisions. This distinction matters for FRQs about costs of monetary integration.
Understanding these systems helps you see why the world moved toward floating rates. Both the gold standard and Bretton Woods provided stability but ultimately couldn't accommodate the flexibility modern economies needed.
Compare: Gold Standard vs. Bretton Woods—both anchored currencies to gold, but Bretton Woods used the dollar as an intermediary. Both failed when the constraint on monetary policy became too costly. This historical context helps explain why most countries now prefer floating or managed systems.
| Concept | Best Examples |
|---|---|
| Full monetary policy independence | Floating exchange rate, Managed float |
| No monetary policy independence | Currency board, Dollarization, Gold standard |
| Market-determined rates | Floating, Managed float |
| Government-maintained rates | Fixed, Pegged, Currency board |
| Historical systems (no longer used) | Gold standard, Bretton Woods |
| Eliminates exchange rate risk entirely | Dollarization, Euro adoption |
| Requires foreign reserve holdings | Fixed, Pegged, Currency board, Managed float |
| Vulnerable to speculative attacks | Pegged, Fixed (without full backing) |
Which two exchange rate systems both eliminate a country's ability to conduct independent monetary policy, and what distinguishes them from each other?
A country experiencing a trade deficit has a floating exchange rate. Explain the automatic adjustment mechanism that should occur, connecting your answer to the exchange rate effect on aggregate demand.
Compare and contrast a currency board with dollarization—what do they share, and why might a country choose one over the other?
If an FRQ describes a country that wants exchange rate stability but also wants to retain some ability to adjust its currency value over time, which system best fits this description? Explain why.
Why did both the gold standard and the Bretton Woods system ultimately collapse? What does this reveal about the fundamental trade-off in exchange rate system design?