Solution

To combine the two extreme positions, `fixed’ and ‘flexible’, the following exchange rate arrangements are used by governments to bring stability in external accounts:

1. Wider Bands

A system that allows adjustment in fixed exchange rate is referred to as wider bands. It permits only 10% variation between the currencies of any two countries. For example, a country can improve its balance of payments (BoP) deficit by depreciating it’s currency, which leads to increase in demand for domestic goods due to increase in purchasing power of other currencies. This further leads to the increase in exports, hence improving the BoP.

2. Crawling Peg

Crawling peg system allows continuous and regular adjustments in the exchange rate. Only 1% of variation is allowed at a time.

3. Managed floating

Managed floating is a scheme under which government can intervene to vary the exchange rate when the situation demands so. There is no specific limit of variation as in crawling peg and wider bands.