Exchange Rate Regimes

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’ll start by learning about the concept itself, and will continue with each regime type, starting with the ones with highest monetary policy independence, and moving to less independent regimes.

Definition:

Exchange rate regimes, a simple definition and a list of types.

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:

Exchange rate regimes: Flexible exchange rate

Flexible exchange rates can be defined as exchange rates determined by global supply and demand of currency. In other words, they are prices of foreign exchange determined by the market, that can rapidly change due to supply and demand, and are not pegged nor controlled by central banks. The opposite scenario, where central banks intervene in the market with purchases and sales of foreign and domestic currency in order to keep the exchange rate within limits, also known as bands, is called fixed exchange rate.

Within this pure definition of flexible exchange rate, we can find two types of flexible exchange rates: pure floating regimes and managed floating regimes. On the one hand, pure floating regimes exist when, in a flexible exchange rate regime, there are absolutely no official purchases or sales of currency.  On the other hand, managed (also called dirty) floating regimes, are those flexible exchange rate regimes where at least some official intervention happens.

Flexible exchange rate regimes were rare before the late twentieth century. Prior to World War II, governments used to purchase and sell foreign and domestic currency in order to maintain a desirable exchange rate, especially in accordance with each country’s trade policy. After a few experiences with flexible exchange rates during the 1920s, most countries came back to the gold standard. In 1930, before a new wave of flexible rate regimes started, prior to the war, over 50 countries were on the gold standard. However, most countries would abandon it just before World War II started.

In 1944, with the war almost over, international policy coordination was starting to make sense in everybody’s mind. Along with other international organisations created during those years, the Bretton Woods agreement was signed, putting in place a new pegging system: currencies were pegged to the dollar, which in turn was pegged to gold. It was not until 1973, when Bretton Woods completely collapsed, that countries started to implement flexible exchange rate regimes.

Milton Friedman was a great advocate for floating exchange rates. In his article “The Case for Flexible Exchange Rates”, 1953, he pointed out the extent to which flexible exchange rates would improve the global economy, by means of monetary independence. Also, economists Robert Mundell and Marcus Fleming, as demonstrated by the IS-LM-BoP model that derives from their works, pointed out how hurtful fixed exchange rates can be. All this relates to the “impossible trinity” concept.

Exchange rate regimes: Free float

A free floating exchange rate, sometimes referred to as clean or pure float, is a flexible exchange rate system solely determined by market forces of demand and supply of foreign and domestic currency, and where government intervention is totally inexistent. Clean floats are a result of laissez-faire or free market economics.

Clean float is, theoretically, the best way to go. It allows countries to retain their monetary independence, which basically means they can focus on the internal aspects of their economy, and control inflation and unemployment without worrying about external aspects. However, we must take into consideration external shocks, such as oil price rises or capital flights, which can make it impossible to maintain a purely clean floating exchange rate system.

In reality, almost none of the currencies of developed countries have a clean float, as they all have some degree of support from their corresponding central bank, and so have a managed float. In fact, since most countries intervene in foreign exchange markets to some extent from time to time, these can be considered managed floating systems. The International Monetary System, which oversees the correct functioning of the international monetary system and monitors its members’ financial and economic policies, “allows” for exchange rate intervention when there are clear signs of risk to any of its member’s economy.

Exchange rate regimes: Managed float

A managed or dirty float is a flexible exchange rate system in which the government or the country’s central bank may occasionally intervene in order to direct the country’s currency value into a certain direction. This is generally done in order to act as a buffer against economic shocks and hence soften its effect in the economy.

A managed float is halfway between a fixed exchange rate and a flexible one as a country can obtain the benefits of a free floating system but still has the option to intervene and minimize the risks associated with a free floating currency. For example, if a currency’s value increases or decreases too rapidly, the central bank may decide to intervene in order to minimize any harmful effects that might result from the otherwise radical fluctuation. This is especially the case when international trade might be affected: central banks might act to counter a large appreciation of their currency, in order to maintain net exports. For instance, in 1994 the American government decided to buy large amounts of Mexican pesos with the objective of stopping the rapid loss in value of the peso, so to keep the trade status quo.

Even though most developed countries use a flexible exchange rate regime, in truth, they all use it to a limit. In fact, since most countries intervene in foreign exchange markets to some extent from time to time, these can be considered managed floating systems. The International Monetary System, which oversees the correct functioning of the international monetary system and monitors its members’ financial and economic policies, “allows” for exchange rate intervention when there are clear signs of risk to any of its member’s economy.

Exchange rate regimes: Crawling peg

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.

Exchange rate regimes: Target zone

A target zone arrangement is an agreed exchange rate system in which certain countries pledge to maintain their currency exchange rate within a specific fluctuation margin or band. This margins can be set vis-à-vis another currency, a cooperative arrangement (such as the ERMII), or a basket of currencies. The spread of this margin can however vary, giving way to two different versions:

Strong version: also known as conventional fixed peg arrangements. The exchange rate, fluctuates within margins of ±1% or less, and is revised quite infrequently.  The monetary authority can maintain the exchange rate within margins through direct intervention (for instance, purchasing and selling domestic and foreign currency in the market) or through indirect intervention (for instance influencing on interest rates). The flexibility of monetary policy is larger than for exchange arrangements with no separate legal tender.

Weak version: also known as pegged exchange rates within horizontal bands. In this case, the exchange rate fluctuates more than ±1% around the fixed central rate. Here, there is a limited degree of monetary policy discretion.

Target zone arrangements can be seen as being half way between fixed and flexible exchange rates. This kind of exchange rate system therefore allows for relatively stable trading conditions to prevail between countries, and at the same time allows some fluctuation in foreign exchange rates depending on relative economic conditions and trade flows.

Exchange rate regimes: Fixed exchange rate

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.

Exchange rate regimes: Currency board

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.

Exchange rate regimes: No separate legal tender

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.

Exchange rate regimes: 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 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.