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:

A currency board is an exchange rate regime based on the full convertibility of a local currency into a reserve one, by a fixed exchange rate and 100 percent coverage of the monetary supply backed up with foreign currency reserves. Therefore, in the currency board system there can be no fiduciary issuing of money. As defined by the IMF, a currency board agreement is “a monetary regime based on an explicit legislative commitment to exchange domestic currency for a specific foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority”. For currency boards to work properly, there has to be a long-term commitment to the system and automatic currency convertibility. This includes, but is not limited to, a limitation on printing new money, since this would affect the exchange rate.

The first currency boards appeared during the nineteenth century in Britain and France’s colonies. Since for locals of those colonies using the metropolitan currency was risky (loss or destruction of notes and coins, resources being permanently locked into the currency), the implementation of currency boards in the colonies made sense. The principle of the currency board was thus created in 1844 by the British Bank Charter Act.

The advantages of using a currency board includes low inflation, economic credibility, and lower interest rates. However, there is practically no monetary independence as monetary policies will focus in maintaining the coverage of the reserve’s monetary supply in detriment of other domestic considerations. The central bank will no longer act as a lender-of-last-resort, and monetary policy will be strictly limited to that allowed by the banking rules of the currency board arrangement.

Examples include the Bulgarian lev against the Euro, or the Hong Kong dollar against the U.S. dollar.

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:

Under a no separate legal tender regime, a country uses another one’s currency and thus gives away its capacity of using monetary policies. As stated by the IMF, under an exchange arrangement with no separate legal tender, “the currency of another country circulates as the sole legal tender, or the member belongs to a monetary or currency union in which the same legal tender is shared by the members of the union”. Following this definition, we could include every country in the Eurozone. However, since in that case a new central governing entity, the European Central Bank, was created, it is considered as a pure monetary union.

The most widely used example of an exchange arrangement with no separate legal tender is a formal dollarization. In this case, the country adopts the dollar as its currency. The most common examples are the cases of Ecuador, Panama and El Salvador. El Salvador is a rare case since dollars coexist with the former domestic currency, the colón. However, the printing of new colones is prohibited, so they will coexist with dollars until all colón notes wear out physically.

The main implication for a country to adopt an exchange arrangement with no separate legal tender is that it completely surrenders its control over monetary policy. Therefore, usually this regime is adopted by governments that are considered as non-reliable, substituting their currency in favour of a currency of another country considered to be stable and with an effective monetary policy.

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:

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 19^th 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: