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:
- Exchange rate regime
High independence:
Decreasing independence:
Low independence:
An exchange rate regime is the system that a country’s monetary authority, -generally the central bank-, adopts to establish the exchange rate of its own currency against other currencies. Each country is free to adopt the exchange-rate regime that it considers optimal, and will do so using mostly monetary and sometimes even fiscal policies.
The distinction amongst these exchange rates regimes is generally just made between fixed and flexible exchange rate regimes, but we find there are many other different regimes, some of which are in between these extreme cases:
–Monetary Union, with a shared currency, such as the Eurozone;
–No separate legal tender, where the use of the currency of another country takes place;
–Currency Board, an explicit agreement on a fixed exchange rate between two or more currencies;
–Target zone arrangement, where the exchange rate is allowed to fluctuate within certain bands;
–Crawling Peg, with a periodically adjusted exchange rate;
–Managed (dirty) float, a flexible exchange rate regime with some government intervention;
–Free (clean) float, the exchange rate is market determined.
The “impossible trinity”, also referred to as “trilemma”, states that any exchange rate regime will only have two of the following three characteristics: free capital flow, fixed exchange rate regime; and sovereign monetary policy; and thus, one is always left out.
Every exchange rate regime obviously has its particularities, virtues and flaws. To determine the most appropriate exchange-rate regime for a certain country is not a simple task as much will be at stake. A country’s economy is hugely affected by this decision. 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:
