Subject 5. Exchange Rate Regimes

The exchange rate regime is the way a country manages its currency in relation to other currencies and the foreign exchange market.

An ideal currency regime would have three properties:

  • The exchange rate between any two currencies would be credibly fixed.
  • All currencies would be fully convertible.
  • Each country would be able to undertake fully independent monetary policy in pursuit of domestic objectives, such as growth and inflation targets.

However, these conditions are not consistent. A country cannot have a fixed exchange rate and fully convertible currency without giving up its ability to implement independent monetary policy.

In a flexible exchange rate regime, the exchange rate is determined by the market forces of supply and demand, and therefore fluctuates freely in the market. The central bank intervenes in the foreign exchange market only to smooth temporary imbalances. The advantages are that the exchange rate reflects economic fundamentals at a given point in time and governments are free to adopt independent monetary and fiscal policies. However, exchange rates can be extremely volatile in this regime.

A fixed exchange rate is an exchange rate that is set at a determined amount by government policy. The distinguishing characteristic of a fixed rate, unified currency regime is the presence of only one central bank with the power to expand and contract the supply of money. Those linking their currency at a fixed rate to the U.S. dollar or the euro are no longer in a position to conduct monetary policy. They essentially accept the monetary policy of the nation to which their currency is tied. They also accept the exchange-rate fluctuations of that currency relative to other currencies outside of the unified zone.

In practice, most regimes fall between these extremes. The type of exchange rate regime used varies widely among countries and over time.

No Separate Legal Tender

In this regime a country does not have its own legal tender. There are two sub-types:

  • Dollarization. The country uses another country's currency as its domestic currency. The benefit is the elimination of exchange rate fluctuations. However, this leads to the loss of monetary policy autonomy.
  • Monetary union. In this case a group of countries share a common currency, e.g., the European Union and the euro.

Currency Board System

The monetary authority is required to maintain a fixed exchange rate with a foreign currency. Its foreign currency reserves must be sufficient to ensure that all holders of its own currency can convert them into the reserve currency. That is, the monetary authority will only issue one unit of local currency for each unit of foreign currency it has in its vault.

The major benefit is currency stability and the main drawback is the loss of ability for the country to set its own monetary policy.

Fixed Parity

The country tries to keep the value of its currency constant against another country but it has no legal obligation to do so. This is also known as the pegged exchange rate system. There can be a very small percentage allowable deviation (band) on both sides of the rate.

Target Zone

This is a fixed parity with a somewhat wider band.

Crawling Peg

In this case, the exchange rate is fixed and then adjusted periodically to keep pace with the inflation rate.

Crawling Band

This is initially a fixed parity, followed by widening band around the central parity. It is used to gradually exit from the fixed parity.

Managed Float

A country's exchange rate is adjusted based on the country's internal or external targets.

Independently Float

In this case, the market determines the exchange rate.

User Contributed Comments 2

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vatsal92: - Flexible/Independent Float - Determined by market forces.
- Fixed - Determined by government policy.
- Dollarization - Another country's currency as its domestic currency.
- Monetary Union - Group of countries sharing a common currency.
- Currency Board Arrangement  Explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate.
- Conventional Fixed Peg Arrangement  Country pegs its currency within margins of +/- 1% versus another currency.
- Pegged Exchange Rates within Horizontal Bands/Target Zone - Margins are wider.
- Crawling Peg - Exchange rate is fixed, and adjusted periodically for inflation.
- Crawling Band - Initially a fixed parity, followed by widening band around the central parity. This is used to gradually exit from fixed parity.
- Managed Float - Exchange rate adjusted based on country's internal or external targets.
unknown: @vatsal92 Cheers