Global Exchange Rate Arrangements
By
Mahir Mahtab Haque
ID: B17231042
What is Exchange Rate Regime?
• It is a system adopted by a country’s central bank 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.
• 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 “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 & sovereign monetary policy; thus,
one is always left out.
Classification of Exchange Rate Arrangements
The 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
Flexible Exchange Rates
Determined by global
Not pegged nor controlled
demand & supply of
by central banks
currency
Milton Friedman believed this
2 types
exchange rate would improve
pure floating regimes & global economy through monetary
managed floating regimes independence
Free Floating Exchange Rate
Referred to as ●
Solely determined by market forces of demand and
supply of foreign and domestic currency
clean/pure float ●
Government intervention is totally nonexistent
●
Allows countries to retain their monetary independence
Benefits ●
Controls inflation and unemployment without having to
worry about external aspects
Current ●
External shocks can make it impossible to maintain a purely
clean floating exchange rate system
●
Most developed countries maintain a managed float, for some
scenario degree of support from their corresponding central banks
Countries: USA, Germany, France, UK, Japan, Canada, etc.
Managed Floating Exchange Rate
Referred to ●
Government/central bank may occasionally
intervene in order to direct the country’s currency
as Dirty ●
value into a certain direction
Acts as a buffer against economic shocks and hence
Float soften its effect in the economy
Benefit ●
●
Mixture of a fixed & flexible exchange rate
Can obtain the benefits of a free floating system
& still has the option to intervene and minimize
s the risks associated with a free floating currency
Countries: Kenya, South Korea, Argentina, India, etc.
Crawling Peg
●
A fixed par value of the currency which is frequently
Defined by revised and adjusted due to market factors
2 main characteristics ●
A band of rates within which it is allowed to fluctuate
According to ●
Currency is adjusted periodically in small amounts at a fixed rate or in
response to changes in selective quantitative indicators, (past inflation
differentials vis-à-vis major trading partners, differentials between inflation
IMF target and expected inflation in major trading partners)
Scopes
●
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)
Limits monetary policymaking, to a similar degree than for target zone arrangements.
Benefits
●
●
These characteristics allow for progressive devaluation of the currency which has a
less traumatic effect in the country’s economy.
●
This helps prevent, or at least soften, speculation over the currency.
Countries: Nicaragua, Panama, Saudi Arabia (with US Dollar as anchor)
Target Zone
An agreed exchange rate system in which certain countries pledge to maintain their
currency exchange rate within a specific fluctuation margin or band. This margin can
be set vis-à-vis another currency, a cooperative arrangement (ERMII), or a basket of
currencies.
Strong Version: Fluctuates Weak Version: Fluctuates
within margins of ±1% or less, more than ±1% around the fixed
and is revised quite central rate. Here, there is a limited
infrequently. degree of monetary policy discretion.
The spread of this margin The monetary authority can Target zone arrangements can be
seen as being half way
can however vary, giving maintain the exchange rate between fixed and flexible exchange
way to Strong Version & within margins through direct rates, this allows for relatively stable
Weak Version. intervention (purchasing and trading conditions to prevail between
selling domestic and foreign countries, and at the same time
allows some fluctuation in foreign
currency in the market) or exchange rates depending on relative
through indirect intervention economic conditions and trade
(influencing on interest rates). flows .
Fixed Exchange Rate
Referred to as pegged
exchanged rate
An exchange rate regime under which the currency of a country Monetary authority determines the exchange rate
is fixed, either to another country’s currency, a basket of and commits itself to buy or sell the domestic
currencies or another measure of value, such as gold currency at that price
Central bank intervenes in Brings stabilization to the real economic Main disadvantage is the impossibility of adjusting the balance of
activity as it reduces volatility and
the foreign exchange market fluctuations in relative prices. trade and the need for governments to have a foreign asset
and changes interest rates Also, eliminates the exchange rate risk. reserve in order to defend the fixed exchange rate
Currency Board
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.
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.
Advantages include low
inflation, economic credibility,
Disadvantages include 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.
and lower interest rates.
Countries: Hong Kong, Grenada, Dominica (with US Dollar as anchor)
No separate legal tender
Under an exchange arrangement with no The main implication for a country to adopt an
separate legal tender, “the currency of another exchange arrangement with no separate legal
tender is that it completely surrenders its control
country circulates as the sole legal tender, or
over monetary policy. Therefore, usually this
the member belongs to a monetary or currency
regime is adopted by governments that are
union in which the same legal tender is shared
considered as non-reliable, substituting their
by the members of the union”. currency in favor of a currency of another country
Following this definition, we could include considered to be stable and with an effective
every country in the Euro zone. monetary policy.
Countries: Ecuador, El Salvador (with US Dollar as legal tender)
Monetary Union
Also known as ●
●
An exchange rate regime where two or more countries use the same currency
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
currency union irreversible convertibility of the currencies of those countries is required.
●
As explained by the impossible trilemma, in a monetary union there is exchange rate stability and a
Implications ●
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,
●
Disappearance of the uncertainty in the fluctuation of exchange
Advantages rates, lower transaction costs between countries, higher monetary
stability and inflation controlling by the national central bank.
●
Loss of monetary policy independence, the emergence of
Disadvantages problems due to the initial establishment of parities or the
difficulties in establishing full capital mobility.
Thank You!
