Exploring Exchange Rate Regimes | CFA Level I Economics
Welcome back! In this lesson, we’ll dive into the various types of exchange rate regimes and their implications on the flexibility of monetary policy. So, buckle up and let’s get rolling!
Exchange Rate Regimes: An Overview
Almost every exchange rate is managed to some extent by central banks. The exchange rate regime refers to the policy framework that the central bank adopts to manage the exchange rate. The IMF categorizes exchange rate regimes into two types for countries that do not issue their own currencies and seven types for countries that issue their own currencies.
Countries without Their Own Currencies
For countries that do not have their own currencies, they can either:
- Use the currency of another country (formal dollarization)
- Be part of a monetary union in which several countries use a common currency
Formal dollarization: In this case, a country cannot have its own monetary policy. For example, Panama adopts the US dollar as the country’s currency. It inherits the US dollar’s credibility but not the credit-worthiness of the US government. Bank deposits in Panama are not backed by deposit insurance from the US central bank, so the interest rates for US dollar deposits in Panama differ from those in the US.
Monetary union: The most obvious example is the European Economic and Monetary Union. Although member countries cannot have their own monetary policies, they jointly determine monetary policy through their representation at the European Central Bank. Like dollarization, the countries inherit the credibility of the Euro but not the credit-worthiness. The government bonds of the various Eurozone nations have vastly different yields.
Countries with Their Own Currencies
For countries that have their own currency, there are 7 different exchange rate regimes:
- Currency board arrangement: This involves an explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate. The domestic currency is fully backed by foreign assets. The Hong Kong Dollar is a classic example. Under this arrangement, the central bank gives up the ability to conduct independent monetary policy and essentially imports the inflation rate of the pegged currency’s economy in the long run.
- Conventional fixed peg arrangement: A country pegs its currency within margins of ±1% versus another currency or a basket of currencies. The central bank maintains exchange rates within the band by purchasing or selling foreign currencies in the foreign exchange markets (direct intervention) and adjusting the policy interest rate (indirect intervention). This regime allows the central bank to retain more flexibility to conduct monetary policy, but there are still limitations due to the requirement to maintain the peg.
- Target zone regime: This regime allows for wider fluctuations in currency value relative to another currency or basket of currencies (e.g., ±2%). Compared to a conventional peg, the central bank has more policy discretion because the bands are wider.
- Crawling peg: The exchange rate is adjusted periodically, typically to adjust for differences in inflation against the currency used in the peg. Passive crawling pegs involve adjustments made as needed, while active crawling pegs involve planned and announced adjustments in advance. Monetary policy is restricted in much the same way as with a fixed peg arrangement.
- Crawling bands regime: The width of the band that the central bank allows the exchange rate to fluctuate is increased over time. The band is initially tight for a developing country to anchor expectations about future inflation to investors. When the country attains credibility, the bands are widened, allowing the central bank more flexibility and greater scope for monetary policy. This system has the desirable property of enabling a gradual exit strategy from a fixed peg.
- Managed float regime: Under this regime, the exchange rate target and band are typically not fixed and not explicitly made known to the public. The central bank decides whether to intervene based on its policy objectives, like achieving trade balance, price stability, or employment levels. This regime provides the central bank with higher flexibility to implement monetary policy than previous regimes, but such management of exchange rates may induce trading partners to respond in ways that reduce stability.
- Independent float: In this regime, the exchange rate is market-determined, so there is no exchange rate target or trading band. Central banks may intervene at times to slow the rate of change and reduce short-term volatility, but the aim is not to maintain exchange rates at a target level. This regime allows the central bank to have the most flexibility in implementing monetary policy.
And there you have it, the exchange rate regimes as defined by the IMF! In our next lesson, we’ll learn the effects of exchange rates on international trade and capital flows. See you again soon!