International Financial Management

Paper Code: MS 509

Topic: Exchange Rate Regimes
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.

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

Flexible exchange rate

High independence Free (clean) float

Managed (dirty) float

Crawling peg

Decreasing independence Target zone arrangement

Fixed exchange rate

No separate legal tender, such as Dollarization / Demonetization

Low independence
Monetary union, such as the Euro zone.

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.

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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
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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
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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

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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 19th 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.

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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.
Determinants of Exchange Rate
There are several factors that influence the exchange rate through their effects on the currency demand
and supply; the important among them are as follows:
A. Inflation Rates: Inflation influences exchange rates by affecting the competitiveness of the
country’s goods and services in the international market. Due to inflation, a country’s exports
become costlier and thus fail to compete in the international market. As a result, the country’s
exports would decline, leading to a decline in the supply of foreign currency. The competitiveness
of exports of two countries depends on the relative rate of inflation in two countries. For instance,
if inflation rate in India is higher than the US, obviously, it will reduce exports from India to the
US and will increase exports from US to India. It will ultimately appreciate the exchange rate of
dollar against rupee.
B. Economic Growth: The country’s economic growth rate also influences the demand and supply of
foreign currency. The higher the economic growth rate, the more economic transactions both
within the country and across countries (exports and imports) will take place. This will cause
outflow and inflow of foreign currencies and thus influencing their demand and supply.
C. Interest Rates: The interest rate in the economy also influences the exchange rate through supply
and demand for foreign exchange. When interest rate in an economy increases, foreign investors
pump in more funds, which increases the supply of foreign currency and fall in the value against
the home currency. Similarly, if the interest rates in other countries rise, there will be a shift of
invisible funds to them, leading to an increase in the exchange rate of other currencies. Thus, the
increase and decrease in interest rates in the economy results an increase or decrease in the supply
and demand for foreign currency. However, the increase or decrease in interest rates would be
effective only if the relative change in interest rate is more than that in other countries.
D. Speculation: Speculators in foreign exchange market may also influence the demand and supply of
foreign currency. When the speculators purchase more foreign currency, the value of foreign
currency will go up as a result of increased demand. The reverse effect will be seen when the
speculators sell more foreign currency. The purchase and sell of foreign currency depend on the
activities in forward exchange market. The matter of the fact is that the forward rates influence the
spot exchange rates.
E. Money and Credit Policy: The inflation rates and interest rates to a great extent are also governed
by the monetary policy of the country. If a country adopts tight monetary policy, the money supply
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 will be comparatively less. This will lead to less inflation and more exports from the country and
appreciation in exchange rate. The tight monetary policy not only reduces inflation, but also keeps
high interest rate to control inflation, which in its turn invite more foreign funds into the country.
Cheap money policy has reverse effects.
F. Political Factors: Political stability in the country may attract a large amount of investments from
foreign institutions, as investors find the country to be less risky and more rewarding for their
investments. On the contrary, political instability in a country may drive away investors from the
country and cause the outflow of funds. The policies / ideology of the ruling party in a country also
influence the exchange rate. Some political decisions and activities also influence the exports and
imports of the country, thereby influencing the exchange rate.
G. Government Controls: supply of foreign exchange. The Governments may also directly intervene
in Governments may impose several controls and restrictions on the exports and imports,
remittances of funds and investments. All such controls influence the demand and the foreign
exchange market to influence the exchange rate as per the need of economy. Therefore, exchange
rates are highly susceptible to government controls, interventions and policies.
H. Productivity of an Economy: Increasing productivity in an economy should positively influence
the value of its currency. Its effects are more prominent if the increase is in the traded sector.
I. Balance of Trade Levels and Trends: The trade flow between countries illustrates the demand for
goods and services, which in turn indicates demand for a country's currency to conduct trade.
Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's
economy. For example, trade deficits may have a negative impact on a nation's currency.

J. Market Psychology: Market psychology and trader perceptions influence the foreign exchange
market in a variety of ways:
o Flights to quality: Unsettling international events can lead to a "flight to quality", a type of
capital flight whereby investors move their assets to a perceived "safe haven". There will be a
greater demand, thus a higher price, for currencies perceived as stronger over their relatively
weaker counterparts. The U.S. dollar, Swiss franc and gold have been traditional safe havens
during times of political or economic uncertainty.
o Long-term trends: Currency markets often move in visible long-term trends. Although
currencies do not have an annual growing season like physical commodities, business cycles do
make themselves felt. Cycle analysis looks at longer-term price trends that may rise from
economic or political trends.
o "Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is
the tendency for the price of a currency to reflect the impact of a particular action before it occurs
and, when the anticipated event comes to pass, react in exactly the opposite direction. This may
also be referred to as a market being "oversold" or "overbought". To buy the rumor or sell the fact
can also be an example of the cognitive bias known as anchoring, when investors focus too much
on the relevance of outside events to currency prices.
o Economic numbers: While economic numbers can certainly reflect economic policy, some
reports and numbers take on a talisman-like effect: the number becomes important to market
psychology and may have an immediate impact on short-term market moves. "What to watch"
can change over time. In recent years, for example, money supply, employment, trade balance
figures and inflation numbers have all taken turns in the spotlight.
o Technical trading considerations: As in other markets, the accumulated price movements in a
currency pair such as EUR/USD can form apparent patterns that traders may attempt to use.
Many traders study price charts in order to identify such patterns.

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