An exchange-rate regime is the way an authority manages its currency in relation to other currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent on many of the same factors, such as economic scale and openness, inflation rate, elasticity of labor market, financial market development, capital mobility etc.
A currency, in the most specific sense is money in any form when in use or circulation as a medium of exchange, especially circulating banknotes and coins. A more general definition is that a currency is a system of money in common use, especially for people in a nation. Under this definition, US dollars (US$), pounds sterling (£), Australian dollars (A$), European euros (€), Russian rubles (₽) and Indian Rupees (₹) are examples of currencies. These various currencies are recognized as stores of value and are traded between nations in foreign exchange markets, which determine the relative values of the different currencies. Currencies in this sense are defined by governments, and each type has limited boundaries of acceptance.
The foreign exchange market is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the Credit market.
Monetary policy is the process by which the monetary authority of a country, typically the central bank or currency board, controls either the cost of very short-term borrowing or the money supply, often targeting inflation or the interest rate to ensure price stability and general trust in the currency.
There are two major regime types: fixed (or pegged) exchange rate regimes, where the currency is tied to another currency, mostly reserve currencies such as the U.S. dollar or the euro or a basket of currencies; floating (or flexible) exchange rate regimes, where the economy dictates movements in the exchange rate. However, the distinctions between fixed and floating exchange rate regimes are not so cut and dried in reality. Thus, there are also intermediate exchange rate regimes.
A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed against either the value of another single currency, a basket of other currencies, or another measure of value, such as gold.
The euro is the official currency of 19 of the 28 member states of the European Union. This group of states is known as the eurozone or euro area, and counts about 343 million citizens as of 2019. The euro is the second largest and second most traded currency in the foreign exchange market after the United States dollar. The euro is divided into 100 cents.
A floating exchange rate is a type of exchange-rate regime in which a currency's value is allowed to fluctuate in response to foreign-exchange market events. A currency that uses a floating exchange rate is known as a floating currency. A floating currency is contrasted with a fixed currency whose value is tied to that of another currency, material goods or to a currency basket.
This classification of exchange rate regime is based on the classification method carried out by GGOW (Ghosh、Guide、Ostry and Wolf, 1995, 1997), which combined the IMF de jure classification with the actual exchange behavior so as to differentiate between official and actual policies. The GGOW classification method is also called Trichotomy Method.
Floating (or flexible) exchange rate regimes are those in which a country's exchange rate fluctuates in a wider range and the government makes no attempt to fix it against any base currency. Appreciations and depreciations may occur from year to year, each month, by the day, or every minute. They can be divided into two types——free float and managed float.
Managed float regime is the current international financial environment in which exchange rates fluctuate from day to day, but central banks attempt to influence their countries' exchange rates by buying and selling currencies to maintain a certain range. The peg used is known as a crawling peg.
Free float
Free float, also known as clean float, signifies that a currency's value is allowed to fluctuate in response to foreign-exchange market mechanisms without government intervention.
Managed float (or dirty float)
Managed float, also known as dirty float, involves government intervention in the market exchange rate in different forms and degrees, in an attempt to make the exchange rate change in a direction conducive to the economic development of the country, especially during an extreme appreciation or depreciation.
Currency depreciation is the loss of value of a country's currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system in which no official currency value is maintained. Currency appreciation in the same context is an increase in the value of the currency. Short-term changes in the value of a currency are reflected in changes in the exchange rate.
In accountancy, depreciation refers to two aspects of the same concept:
A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor."
Intermediate
The exchange rate regimes between the fixed ones and the floating ones.
Band
There is only a tiny variation around the fixed exchange rate against another currency, well within plus or minus 2%.
For example, Denmark has fixed its exchange rate against the euro, keeping it very close to 7.44 krone per euro (0.134 euro per krone).
The currency steadily depreciates or appreciates at an almost constant rate against another currency. And the exchange rate follows a simple trend.
Crawling band
Some variation about the rate is allowed, and adjusted as above.
For example, Colombia from 1996 to 2002, and Chile in the 1990s.[1]
Colombia, officially the Republic of Colombia, is a sovereign state largely situated in the northwest of South America, with territories in North America. Colombia shares a border to the west with Panama, to the east with Brazil and Venezuela, and to the south with Ecuador and Peru. It shares its maritime limits with Costa Rica, Nicaragua, Honduras, Jamaica, Haiti, and the Dominican Republic. Colombia is a unitary, constitutional republic comprising thirty-two departments, with the capital in Bogotá.
Chile, officially the Republic of Chile, is a South American country occupying a long, narrow strip of land between the Andes to the east and the Pacific Ocean to the west. It borders Peru to the north, Bolivia to the northeast, Argentina to the east, and the Drake Passage in the far south. Chilean territory includes the Pacific islands of Juan Fernández, Salas y Gómez, Desventuradas, and Easter Island in Oceania. Chile also claims about 1,250,000 square kilometres (480,000 sq mi) of Antarctica, although all claims are suspended under the Antarctic Treaty.
Currency basket peg
A currency basket is a portfolio of selected currencies with different weightings. The currency basket peg is commonly used to minimize the risk of currency fluctuations. For example, Kuwait shifted the peg based on a currency basket consists of currencies of its major trade and financial partners.
A currency basket is a portfolio of selected currencies with different weightings. A currency basket is commonly used to minimize the risk of currency fluctuations. An example of a currency basket is the European Currency Unit that was used by the European Community member states as the unit of account before being replaced by the euro. Another example is the special drawing rights of the International Monetary Fund.
Fixed exchange rate regimes, sometimes called a pegged exchange rate regime, are those in which a country's exchange rate fluctuates in a narrow range (or not at all) against some base currency or to other measure of value over a sustained period, usually a year or longer. A country's exchange rate can remain rigidly fixed for long periods only if the government intervenes in the foreign exchange market in one or both countries.
Currency board is an exchange rate regime in which a country's exchange rate maintain a fixed exchange rate with a foreign currency, based on an explicit legislative commitment. It is a type of fixed regime that has special legal and procedural rules designed to make the peg "harder—that is, more durable." Examples include the Hong Kong dollar against the U.S dollar and Bulgarian lev against the Euro.
Dollarisation, also currency substitution, means a country unilaterally adopts the currency of another country.
Most of the adopting countries are too small to afford the cost of running its own central bank or issuing its own currency. Most of these economies use the U.S dollar, but other popular choices include the euro, and the Australian and New Zealand dollars.
A currency union, also known as monetary union, is an exchange regime where two or more countries use the same currency. Under a currency union (or monetary union), there is some form of transnational structure such as a single central bank or monetary authority that is accountable to the member nations.
Some famous examples of currency union are the Eurozone, CFA and CFP Franc zones. One of the first known examples is the Latin monetary Union set up in the 19th century.
Edwards, Sebastian & Levy Yeyati, Eduardo (2003) "Flexible Exchange Rates as Shock Absorbers," NBER Working Papers 9867, National Bureau of Economic Research, Inc. ().
Kiguel, Andrea & Levy Yeyati, Eduardo (2009) "Back to 2007: Fear of appreciation in emerging economies" ().
Tiwari, Rajnish (2003): Post-Crisis Exchange Rate Regimes in Southeast Asia, Seminar Paper, University of Hamburg. (PDF)
Levy-Yeyati, Eduardo & Sturzenegger, Federico & Reggio, Iliana (2006) "On the Endogeneity of Exchange Rate Regimes," Working Paper Series rwp06-047, Harvard University, John F. Kennedy School of Government. ()
Coudert, Virginie and Cécile Couharde, Currency Misalignments and Exchange Rate Regimes in Emerging and Developing Countries. , 2008.
Related Research Articles
In finance, an exchange rate is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in relation to another currency. For example, an interbank exchange rate of 114 Japanese yen to the United States dollar means that ¥114 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥114. In this case it is said that the price of a dollar in relation to yen is ¥114, or equivalently that the price of a yen in relation to dollars is $1/114.
Listed below is a table of historical exchange rates relative to the U.S. dollar, at present the most widely traded currency in the world. An exchange rate represents the value of one currency in another. An exchange rate between two currencies fluctuates over time. The value of a currency relative to a third currency may be obtained by dividing one U.S. dollar rate by another. For example, if there are ¥120 to the dollar and €1.2 to the dollar then the number of yen per euro is 120/1.2 = 100.
The monetary policy of Sweden is decided by Sveriges Riksbank, the central bank of Sweden. The monetary policy is instrumental in determining how the Swedish currency is valued.
Currency substitution or dollarization is the use of a foreign currency in parallel to or instead of the domestic currency.
Hard currency, safe-haven currency or strong currency is any globally traded currency that serves as a reliable and stable store of value. Factors contributing to a currency's hard status might include the long-term stability of its purchasing power, the associated country's political and fiscal condition and outlook, and the policy posture of the issuing central bank.
A currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target.
European Monetary System (EMS) was an arrangement established in 1979 under the Jenkins European Commission where most nations of the European Economic Community (EEC) linked their currencies to prevent large fluctuations relative to one another.
The impossible trinity is a concept in international economics which states that it is impossible to have all three of the following at the same time:
The Argentine Currency Board pegged the Argentine peso to the U.S. dollar between 1991 and 2002 in an attempt to eliminate hyperinflation and stimulate economic growth. While it initially met with considerable success, the board's actions ultimately failed. In contrast to what most people think, this peg actually did not exist, except only in the first years of the plan. From then on, the government never needed to use the foreign exchange reserves of the country in the maintenance of the peg, except when the recession and the massive bank withdrawals started in 2000.
The Smithsonian Agreement, announced in December 1971, created a new dollar standard, whereby the currencies of a number of industrialized nations were pegged to the US dollar. These currencies were allowed to fluctuate by 2.25% against the dollar. The Smithsonian Agreement was created by the Group of Ten (G-10) nations raised the price of gold to 38 dollars, an 8.5% increase over the previous price at which was the US government had promised to redeem dollars for gold. In effect, the changing gold price devalued the dollar by 7.9%.
Crawling peg is an exchange rate regime that allows depreciation or appreciation to happen gradually. It is usually seen as a part of a fixed exchange rate regime.
The snake in the tunnel was the first attempt at European monetary cooperation in the 1970s, aiming at limiting fluctuations between different European currencies. It was an attempt at creating a single currency band for the European Economic Community (EEC), essentially pegging all the EEC currencies to one another.
A flexible exchange-rate system is a monetary system that allows the exchange rate to be determined by supply and demand.
Domestic liability dollarization (DLD) refers to the denomination of banking system deposits and lending in a currency other than that of the country in which they are held. DLD does not refer exclusively to denomination in US dollars, as DLD encompasses accounts denominated in internationally traded "hard" currencies such as the British pound sterling, the Swiss franc, the Japanese yen, and the Euro.
Besides being the main currency of the United States, the American dollar is used as the standard unit of currency in international markets for commodities such as gold and petroleum. Some non-U.S. companies dealing in globalized markets, such as Airbus, list their prices in dollars.
Fear of floating refers to situations where a country prefers a fixed exchange rate to a floating exchange rate regime. This is more relevant in emerging economies, especially when they suffered from financial crisis in last two decades. In foreign exchange markets of the emerging market economies, there is evidence showing that countries who claim they are floating their currency, are actually reluctant to let the nominal exchange rate fluctuate in response to macroeconomic shocks. In the literature, this is first convincingly documented by Calvo and Reinhart with "fear of floating" as the title of one of their papers in 2000. Since then, this widespread phenomenon of reluctance to adjust exchange rates in emerging markets is usually called "fear of floating". Most of the studies on "fear of floating" are closely related to literature on costs and benefits of different exchange rate regimes.
Robert C. Feenstra, Alan M. Taylor, 2014, International Economics-Worth Publishers
Ye Shujun, 2009, International Economics,Tsinghua University Press,79
Andrea, Inci, 2002, The Evolution of Exchange Rate Regimes Since 1990: Evidence from De Facto Policies, 8
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