# Understanding Exchange Rates and Its Impacts – An Insight
Understanding exchange rates, their types, benefits, drawbacks, and alternatives is crucial to gain an insight into the economic scenario of a country. This article will focus on explaining these aspects with emphasis on Gresham’s law, fixed exchange rates, and the 2022 Sri Lankan crisis.
Gresham’s Law and its Application
Gresham’s law is a financial principle put forward by English financier Thomas Gresham. It states that “bad money drives out good”, which implies that if two types of money are in circulation, people will hoard the more valuable one and spend the less valuable one. Consequently, the less valuable money will dominate the market, while the more valuable money will disappear from circulation.
This principle applies not only to paper currencies but also to commodity currencies and other goods. For instance, during the 2022 economic crisis in Sri Lanka, the Central Bank fixed the exchange rate between the Sri Lankan Rupee and the U.S. Dollar. However, due to this mismatch, people started to avoid using U.S. dollars in official transactions, indicating the dominance of Gresham’s law.
Contrast to Gresham’s Law: Thiers’ Law
On the contrary to Gresham’s Law, Thiers’ Law suggests that “good money drives out bad”. In this case, people prefer high-quality currencies and reject inferior ones. The increasing popularity of private cryptocurrencies exemplifies Thiers’ law.
Fixed Exchange Rate: An Overview, History, and Downfall
A fixed exchange rate, also known as pegged exchange rate, is a regime where the country’s official currency exchange rate is tied to another country’s currency or gold. It aims to maintain a currency’s value within a specific range.
Historically, the fixed exchange rate system was introduced at the Bretton Woods Conference in 1944 to prevent competitive devaluations and promote stability. However, several factors contributed to the downfall of this system, including persistent trade imbalances, inflation, and dwindling U.S. gold reserves.
The Pros and Cons of Fixed Exchange Rates
Fixed exchange rates offer price stability, reduce transaction costs, and foster investor confidence. However, they also have several drawbacks. For instance, countries adopting a fixed exchange rate lose control over their monetary policy. Additionally, these systems are vulnerable to speculative attacks and tie a country’s fortune to the policies of the anchor currency issuer.
Alternatives to Fixed Exchange Rates
Alternatives to fixed exchange rates include floating exchange rates and managed float.
A floating exchange rate, or flexible exchange rate, is determined by the supply and demand in the foreign exchange market. This system allows currencies to adjust freely to economic conditions, trade imbalances, and market forces.
A managed float exchange rate, or dirty float, involves occasional intervention by a country’s central bank or government in the foreign exchange market to influence its currency’s value.
By broadening the understanding of these concepts, we can better identify the signs of economic instability, measure the effectiveness of different monetary policies, and understand how different global markets are interrelated.
