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 fixed exchange rate, also referred to as pegged exchanged rate, is an exchange rate regime under which the currency of a country is fixed, either to another country’s currency, a basket of currencies or another measure of value, such as gold. A country’s monetary authority determines the exchange rate and commits itself to buy or sell the domestic currency at that price. To maintain it, the central bank intervenes in the foreign exchange market and changes interest rates.
The best known example can be found in the Gold Standard, going from 1879 to 1914, where the value of most currencies was denominated and expressed in terms of gold. We find another example in the Bretton Woods system, from 1944 to 1973, where the U.S. dollar was the official reserve asset, and currencies were paired to it.
Fixed exchange regimes usually bring stabilization to the real economic activity as it reduces volatility and fluctuations in relative prices. Furthermore, it eliminates the exchange rate risk. On the contrary the main disadvantage is the impossibility of adjusting the balance of trade and the need for governments to have a foreign asset reserve in order to defend the fixed exchange rate.
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:
