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:
Decreasing independence:
- Crawling peg
- Target zone
- Fixed exchange rate
- Currency board
Low independence:
A crawling peg is an exchange rate system mainly defined by two characteristics: a fixed par value of the currency which is frequently revised and adjusted due to market factors such as inflation; and a band of rates within which it is allowed to fluctuate.
As the IMF puts it, in crawling pegs “the currency is adjusted periodically in small amounts at a fixed rate or in response to changes in selective quantitative indicators, such as past inflation differentials vis-à-vis major trading partners, differentials between inflation target and expected inflation in major trading partners”. The crawling rate can be set in a backward-looking manner (adjusting depending on inflation or other indicators), or in a forward-looking manner (adjusting depending on preannounced fixed rate and/or the projected inflation). It must be noted that maintaining a crawling peg limits monetary policymaking, to a similar degree than for target zone arrangements.
These characteristics allow for progressive devaluation of the currency which has a less traumatic effect in the country’s economy. Furthermore, this technique helps prevent, or at least soften, speculation over the currency. For these reasons, this type of exchange rate system is most commonly used with “weak” currencies. Latin American countries are known for being prone to use the crawling peg exchange system against the United States dollar, where in some cases devaluation can be seen occurring on a daily basis.
The following figure shows the different exchange rate regimes according to four different variables: exchange rate flexibility, loss of monetary policy independence, anti-inflation effect and credibility of the exchange rate commitment:
