Exchange Rate Regimes

International trade is a vital component of the economy of any nation. Also, international trade is highly dependent upon exchange rates. It is for this reason that the choice of the type of exchange rate regimes is very important. To a layman, all exchange rate regimes might appear to be similar.

However, the reality is that these regimes are significantly different from one another.

For instance, the exchange rate system in a country like China is remarkably different from the exchange rate system in a country like the United States.

The differences in the different types of exchange rate regimes, as well as how they impact the economy, have been listed down in this article.

Types of Exchange Rate Regimes

In reality, there are only two types of exchange rate regimes, which are possible viz. the fixed regime and the floating regime.

However, these two systems have several variations within them. Each of these systems is commonly associated with the degree of liberalization of the underlying economy.

Let’s have a closer look at these systems one by one. This will help us understand why certain types of economies prefer certain exchange rate regimes.

1. Fixed Exchange Rate: A fixed exchange rate is a system in which the exchange rate of a currency is not determined by the market. Instead, it is determined by the central bank. The exchange rate of this currency can be fixed in various ways.

   However, a fixed exchange rate is a conservative system that is generally used by conservative countries such as China.

   For instance, the exchange rate of one currency i.e., the Chinese Yuan, could be fixed in relation to another currency such as the United States dollar.

   Alternatively, the exchange rate of one currency could be fixed in relation to a basket of currencies such as the Euro, the dollar, the yen, etc.

   Lastly, the exchange rate of one currency could be fixed in relation to the price of a precious metal such as gold.

   Once the exchange rate is fixed, it is the job of the central bank to ensure that the price changes in the underlying currency closely mirror the price changes in the target with a small margin for error (usually +/- 1%)

   In practice, countries do not really have absolute peg. Maintaining an absolute peg is very difficult from an operational point of view.

   Instead, these countries choose a range that has an upper and lower limit. If the value of the currency fluctuates within this limit, then the central bank takes no action.

   However, as soon as the limit is breached, the central bank takes swift action. This range could be very small i.e., 2% on either side of it could be as large as 75% on either side. Also, the range may or may not be disclosed to the general public.

   An absolute peg is difficult to maintain since it becomes obsolete over time. It is for this reason that many countries follow the crawling peg system. This is where the range of the peg is updated from time to time based on factors such as inflation.

2. Floating Exchange Rate: A floating exchange rate regime is a more liberal regime. It is, for this reason, it is followed by most first world countries such as the United States, the United Kingdom, and almost all countries in the European Union.

   In the floating rate system, the exchange rate is determined by the free market. This means that private parties are allowed to buy and sell foreign currency, and the resultant demand and supply determine the price. Just like the fixed-rate system, the floating rate system also has some variations.

   There are some countries in the world that do not interfere in their currency trading and do not influence its value. Such countries are said to be on a free-float or a clean float.

   On the other hand, there are some other countries that manage their own currency’s value. This means that theoretically, they have a floating rate regime.

   However, implicitly, they do have a range. If the currency value starts to go beyond the given range, then the central bank undertakes proprietary trading meant to stabilize the value of the currency. This is called a managed float or a dirty float.

   It is important to understand that countries are not very honest about the type of exchange rate regime that they follow. It is for this reason that economists have come up with the idea of de-facto regimes and de-jure regimes.

   A country may be claiming to follow a free float. However, its central bank can be seen in operation if the value of the currency fluctuates too much.

   In this case, the de-jure system is the one being claimed i.e., the free float. However, the de-facto system is the one which is actually being followed, which in this case, is a managed float.

The bottom line is that the exchange rate regime is an important part of the entire economic system. This is because it influences important factors such as capital mobility and even exchange rates. The exchange rate regime is the interface between the domestic economy as well as the global economy. Therefore, it is a vital part of the financial system.