An exchange rate regime (or exchange rate mechanism) is a set of rules, regulations and practices used to influence or manage a country’s currency exchange rate relative to other currencies. The exchange rate of a nation's currency has tremendous impact on the whole economy, including growth, stability, inflation, trade, investments and competitiveness. It is no wonder that countries choose to manage their currencies via exchange rate regimes.
- An exchange rate regime (mechanism) is a complex set of rules used by countries to influence their currency’s exchange rate relative to other currencies
- The two main types of exchange rate regimes are floating and fixed
- A country can implement various measures to manage its currency’s exchange rate
Types of exchange rate mechanisms
Under the broadest categorization, we speak about two major types of exchange rate mechanisms:
- floating (flexible) and
- fixed (pegged).
Many countries use a regime that is a combination of the two and economic literature references many intermediary mechanisms such as monetary union, currency board, pegged exchange rate, managed float exchange rate, etc.
A fixed exchange rate regime keeps the value of a nation's currency at a predetermined level against another currency or a basket of currencies. Countries typically fix the value of their national currency to major currencies such as the US dollar, the euro or the British pound. When a nation uses a fixed exchange regime, the country's central bank (or government) is in charge of ensuring that their currency stays at the predetermined level. If the exchange rate moves too much, the monetary authority will actively intervene in the market to keep the currency within the specified boundaries. Fixed exchange rate regimes are useful for controlling inflation and boosting international trade and investment as they guarantee currency stability. On the negative side, the monetary authority has limited room to maneuver in addressing external shocks.
A floating exchange rate regime allows the value of a nation's currency to fluctuate freely based on the forces of demand and supply. In such regimes, the value of the currency reflects the strength and stability of the economy and there are no predetermined exchange rate levels where authorities are required to intervene in the market. Nevertheless, central banks (governments) still intervene in the foreign exchange market even in countries with a floating rate regime if they judge it as necessary to stabilize the currency or influence its value. Under a floating exchange rate regime, authorities will typically influence their currency by changing interest rates or buying/selling currency reserves. A floating currency allows for a high level of flexibility with respect to monetary and fiscal policy but at the same time, the currency is more exposed to market turbulence.
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Example of managing exchange rates
Here's an imagined situation that illustrates how authorities can manage their currencies in practice.
Let’s say that Country A's currency is A, while Country B’s currency is B.
Country A has a lot of exports to Country B but it imports relatively few goods from Country B. Whenever a country exports more than it imports, there is a high demand for its goods, and consequently for its currency. Following the logic of supply and demand, when demand is high, the currency appreciates in value. This means that A is going to appreciate relative to B and the exchange rate of the A/B currency pair will go higher.
At this point, Country A may intervene and take control of the exchange rate as an appreciating A relative to B means that Country B will have to pay a higher price for the same amount of goods it buys from Country A and might therefore decide to buy less.
Country A can take several actions to depreciate its currency relative to B. For starters, it could lower its interest rates, which will most likely help weaken its currency. Country A could also buy high amounts of B to increase the supply of A on the foreign exchange market, which would again lead to a weaker A versus B. Thirdly, Country A may introduce measures that cap the amount of local assets Country B’s residents can buy, which would lower the demand for A in Country B, again making A depreciate versus B.
In all three cases, Country A took active action to manipulate and manage the exchange rate of A/B, in this case, to facilitate bilateral trade.
What is an exchange rate regime?
An exchange rate regime is a set of rules and procedures used by a country to influence its currency’s value compared to other currencies. In most cases, countries can independently decide which exchange rate regime they use and the central bank is the authority that is in charge of ensuring the exchange rate regime is maintained.
What are the main types of exchange rate regimes?
The two broadest categories of exchange rate regimes are floating and fixed exchange rate mechanisms. In a floating regime, the currency is allowed to trade freely on the foreign exchange market while under the fixed regime, the exchange rate of the currency is held at a predetermined level or allowed to move in a very tight range and the authorities will intervene when the currency moves too much.
What exchange rate regime does the United States have?
The United States currently has a floating exchange rate system meaning the value of the US dollar is determined by the market.
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