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:
Low independence:
- No separate legal tender
- Monetary union
A monetary union (also known as currency union) is an exchange rate regime where two or more countries use the same currency. However, in some special cases there may also be a monetary union even if there is more than a single currency, if the currencies have a fixed exchange rate with each other. In that case, total and irreversible convertibility of the currencies of those countries is required. Their parity relationships are fixed irrevocably, without admitting fluctuation of exchange rates. This process is progressively implemented, until reaching full monetary integration.
One of the first known examples of monetary union was the Latin Monetary Union, which was created in the 19th century, when most of Europe’s currencies were still made out of gold and silver. Even though the project failed for a number of reasons, it properly worked for a few decades. The best known example of a current monetary union is found in Europe were 18 countries share the Euro. However it should be said that in this case the monetary union comes along an economic union (thus forming an economic and monetary union), which is not necessarily always the case.
As explained by the impossible trilemma, in a monetary union there is exchange rate stability and a full financial integration enjoyed among the countries in it, at the cost of monetary independence. A common central bank should exist in order to coordinate the adequate monetary policy to assure a correct functioning of the monetary union, independently from national central banks, which lose many of its competencies. Economist Robert Mundell made a great contribution to the analysis on monetary unions in his paper “A Theory of Optimum Currency Areas”, 1961. The theory of optimum currency areas determines the characteristics that are necessary so that monetary unions can be optimal, and therefore sustainable and economically efficient in the long run.
When analysing the impact of monetary unions on the members’ economic performance, there are positive and negative effects. Negative effects of the establishment of a monetary union are, among others: the loss of monetary policy independence, the emergence of problems due to the initial establishment of parities or the difficulties in establishing full capital mobility. Positive effects include: the disappearance of the uncertainty in the fluctuation of exchange rates, lower transaction costs between countries, higher monetary stability and inflation controlling by the supranational central bank.
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:
