Exchange Rate Regimes

1. Exchange Rate Regimes Julie Harris

2. Fixed vs. Floating Fixed Floating • The exchange rate fluctuates in a narrow range (or not at all) against a base currency over a sustained period of time. • Government action is needed to maintain the exchange rate. • The exchange rate fluctuates in a wider range. • No government intervention to fix the exchange rate against a base currency. • Appreciation/Depreciation can occur frequently.

3. Fixed vs. Floating Fixed Floating

4. No Separate Legal Tender Increasingly Floating Increasingly Fixed • Exchange agreements with no separate legal tender come in two forms: • The currency of another country circulates as the sole legal tender. E.g. Ecuador uses the U.S. Dollar – known as “dollarization” • The country belongs to a monetary or currency union in which the same legal tender is shared by the members of the union. E.g. Members of the European Union • These regimes result in a complete surrender of the monetary authorities’ independent control over domestic monetary policy. No Separate Legal Tender (41) Currency Boards (7) Other fixed Pegs (52) Pegged within horizontal bands (6) Crawling peg (5) Managed floating with no pre-determined path for the exchange rate (51) Independently Floating (25)

5. Currency Boards Increasingly Floating Increasingly Fixed • Currency Boards are monetary regimes based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation. E.g. Hong Kong fixes its exchange rate with the U.S. • Domestic currency is issued only against foreign exchange and remains fully backed by foreign assets. • Eliminates traditional central bank functions such as monetary control and lender-of-last-resort. There is very little room for discretionary monetary policy (depends on the strictness of the banking rules in place). No Separate Legal Tender (41) Currency Boards (7) Other fixed Pegs (52) Pegged within horizontal bands (6) Crawling peg (5) Managed floating with no pre-determined path for the exchange rate (51) Independently Floating (25)

6. Other Fixed Pegs Increasingly Floating Increasingly Fixed • The country pegs its currency, at a fixed rate, to another currency or a basket of currencies. • The basket is formed from the currencies of major trading/financial partners and weights reflect the geographical distribution of trade, services, or capital flows. • There is no explicit legislative commitment to keeping the arrangement. • The exchange rate can fluctuate within a narrow range. • The monetary authority attempts to maintain the fixed rate. • Directly: sale/purchase of foreign currencies • Indirectly: interest rate policy, foreign exchange regulations, etc. • Traditional central banking functions are still possible and the monetary authority can adjust the level of the exchange rate (relatively infrequently). No Separate Legal Tender (41) Currency Boards (7) Other fixed Pegs (52) Pegged within horizontal bands (6) Crawling peg (5) Managed floating with no pre-determined path for the exchange rate (51) Independently Floating (25)

7. Pegged within Horizontal Bands Increasingly Floating Increasingly Fixed • Similar to fixed peg systems – currency is maintained within a small margin (bands) around a fixed central rate. • One key difference: also includes arrangements of countries in the exchange rate mechanism of the European Monetary System. E.g. Denmark • There is a limited degree of monetary policy discretion – the amount depends on the band width. No Separate Legal Tender (41) Currency Boards (7) Other fixed Pegs (52) Pegged within horizontal bands (6) Crawling peg (5) Managed floating with no pre-determined path for the exchange rate (51) Independently Floating (25)

8. Crawling Pegs Increasingly Floating Increasingly Fixed • Currency is adjusted periodically in small amounts at a fixed rate or in response to changes in selective quantitative indicators i.e. the exchange rate is allowed to follow a trend. E.g. Columbia • The rate of the crawl can be set to: • generate inflation-adjusted changes in the exchange rate (backward looking) • a preannounced fixed rate and/or below the projected inflation differentials (forward looking) • Constraints on monetary policy are similar to a fixed peg system. No Separate Legal Tender (41) Currency Boards (7) Other fixed Pegs (52) Pegged within horizontal bands (6) Crawling peg (5) Managed floating with no pre-determined path for the exchange rate (51) Independently Floating (25)

9. Managed Floating with No Pre-Determined Path for the Exchange Rate Increasingly Floating Increasingly Fixed • Monetary Authority attempts to influence the exchange rate without having a specific exchange rate path or target. E.g. Afghanistan • Often used to prevent drastic depreciation of the currency (exchange rate crisis) – more common in developing countries. • Indicators for managing the rate are broadly judgmental. E.g. Balance of payments position, international reserves, etc. No Separate Legal Tender (41) Currency Boards (7) Other fixed Pegs (52) Pegged within horizontal bands (6) Crawling peg (5) Managed floating with no pre-determined path for the exchange rate (51) Independently Floating (25)

10. Independently Floating Increasingly Floating Increasingly Fixed • The exchange rate is market-determined. E.g. U.S. • Any official foreign exchange market intervention is aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate (as opposed to establishing a level for the exchange rate). No Separate Legal Tender (41) Currency Boards (7) Other fixed Pegs (52) Pegged within horizontal bands (6) Crawling peg (5) Managed floating with no pre-determined path for the exchange rate (51) Independently Floating (25)

11. Developing Countries Developing vs. Developed Exchange Rate Crisis - Example • Currencies of developing countries tend to be more volatile – they face exchange rate crisis more often. • Most of the floating systems are from developed countries (with the exception of the EU).