Summary
Exchange rates can be understood as the price of one currency in terms of another currency. However, just like for goods and services, we must take into account what determines that price, since governments can influence it, and even fix it. Exchange rate regimes (or systems) are the frame under which that price is determined. From a purely floating exchange rate, to a central bank determined fixed exchange rate, this Learning Path explains the basics of each of these regimes. We start by learning about the concept itself, and continue with each regime type, starting with the ones with highest monetary policy independence, and moving to less independent regimes.Definition:
High independence:
- Flexible exchange rate
- Free float
- Managed float
Decreasing independence:
Low independence:
A managed or dirty float is a flexible exchange rate system in which the government or the country’s central bank may occasionally intervene in order to direct the country’s currency value into a certain direction. This is generally done in order to act as a buffer against economic shocks and hence soften its effect in the economy.
A managed float is halfway between a fixed exchange rate and a flexible one as a country can obtain the benefits of a free floating system but still has the option to intervene and minimize the risks associated with a free floating currency. For example, if a currency’s value increases or decreases too rapidly, the central bank may decide to intervene in order to minimize any harmful effects that might result from the otherwise radical fluctuation. This is especially the case when international trade might be affected: central banks might act to counter a large appreciation of their currency, in order to maintain net exports. For instance, in 1994 the American government decided to buy large amounts of Mexican pesos with the objective of stopping the rapid loss in value of the peso, so to keep the trade status quo.
Even though most developed countries use a flexible exchange rate regime, in truth, they all use it to a limit. In fact, since most countries intervene in foreign exchange markets to some extent from time to time, these can be considered managed floating systems. The International Monetary System, which oversees the correct functioning of the international monetary system and monitors its members’ financial and economic policies, “allows” for exchange rate intervention when there are clear signs of risk to any of its member’s economy.
The following figure shows the different regimes according to four different variables: exchange rate flexibility, loss of monetary policy independence, anti-inflation effect and credibility of the exchange rate commitment:
